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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the Quarterly Period Ended March 31, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 000-50958



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CallWave Inc.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 77-0490995                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)

136 West Canon Perdido Street, Suite A, Santa Barbara, California 93101

(Address of principal executive offices)

(Zip code)

(805) 690-4100

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act.

Large accelerated filer ̈Accelerated filer ̈or a Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act.):    Yes ̈No  x

At April 17, 2006, the number of shares outstanding of the registrants common stock, $0.0001 par value, was 20,750,486.



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CALLWAVE INC.

Form 10-Q

For the Quarter Ended March 31, 2006

INDEX



|                                                                                                                |  |         
|--------------------------------------------------------------------------------------------------------------- |  | --------
|                                                                                                                |  | Page No.
|PART I. FINANCIAL INFORMATION                                                                                   |  |         
|Financial Statements                                                                                            |  |         
|Condensed Consolidated Balance SheetsMarch 31, 2006 (unaudited) and June 30, 2005                              |  | 3       
|Condensed Consolidated Statements of OperationsThree and Nine Months Ended March 31, 2006 and 2005 (unaudited) |  | 4       
|Condensed Consolidated Statements of Cash FlowsNine Months Ended March 31, 2006 and 2005 (unaudited)           |  | 5       
|Notes to Condensed Consolidated Financial Statements (unaudited)                                                |  | 6       
|Managements Discussion and Analysis of Financial Condition and Results of Operations                           |  | 13      
|Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 28      
|Controls and Procedures                                                                                         |  | 28      
|                                                                                                                | 
|PART II. OTHER INFORMATION                                                                                      |  |         
|Legal Proceedings                                                                                               |  | 29      
|Unregistered Sales of Equity Securities and Use of Proceeds                                                     |  | 30      
|Defaults Upon Senior Securities                                                                                 |  | 30      
|Submission of Matters to a Vote of Security Holders                                                             |  | 30      
|Other Information                                                                                               |  | 30      
|Exhibits                                                                                                        |  | 30      
|Signatures                                                                                                      |  | 31      
|Exhibit Index                                                                                                   |  | 32      
|Certifications                                                                                                  |  |         



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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CALLWAVE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)



|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------ | - | ----------------- | - | ------ | -
|                                                                                                                                                                                                                      |  | As ofMarch 31,2006 |        |   | As ofJune 30,2005 |  
|                                                                                                                                                                                                                      |  | (unaudited)        |        |   |                   |  
|ASSETS                                                                                                                                                                                                                |  |                    |        |   |                   |   |        |  
|Current assets:                                                                                                                                                                                                       |  |                    |        |   |                   |   |        |  
|Cash and cash equivalents                                                                                                                                                                                             |  | $                  | 20,600 |   |                   | $ | 16,828 |  
|Marketable securities                                                                                                                                                                                                 |  |                    | 41,702 |   |                   |   | 39,996 |  
|Restricted cash                                                                                                                                                                                                       |  |                    |       |   |                   |   | 335    |  
|Accounts receivable; net of allowance for doubtful accounts of $315 and $370                                                                                                                                          |  |                    | 3,819  |   |                   |   | 5,676  |  
|Inventory                                                                                                                                                                                                             |  |                    |       |   |                   |   | 454    |  
|Prepaid income tax                                                                                                                                                                                                    |  |                    | 179    |   |                   |   | 113    |  
|Other current assets                                                                                                                                                                                                  |  |                    | 507    |   |                   |   | 476    |  
|Total current assets                                                                                                                                                                                                  |  |                    | 66,807 |   |                   |   | 63,878 |  
|Property and equipment, net                                                                                                                                                                                           |  |                    | 1,772  |   |                   |   | 2,024  |  
|Intangible assets-net                                                                                                                                                                                                 |  |                    | 546    |   |                   |   |       |  
|                                                                                                                                                                                                                      |  |                   
|Deferred tax asset                                                                                                                                                                                                    |  |                    |       |   |                   |   | 2,929  |  
|Other assets                                                                                                                                                                                                          |  |                    | 66     |   |                   |   | 414    |  
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|Total assets                                                                                                                                                                                                          |  | $                  | 69,191 |   |                   | $ | 69,245 |  
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|Liabilities And Stockholders Equity                                                                                                                                                                                  |  |                    |        |   |                   |   |        |  
|Current liabilities:                                                                                                                                                                                                  |  |                    |        |   |                   |   |        |  
|Accounts payable                                                                                                                                                                                                      |  | $                  | 839    |   |                   | $ | 801    |  
|Accrued payroll                                                                                                                                                                                                       |  |                    | 825    |   |                   |   | 1,014  |  
|Deferred revenue                                                                                                                                                                                                      |  |                    | 287    |   |                   |   | 1,587  |  
|Other current liabilities                                                                                                                                                                                             |  |                    | 1,924  |   |                   |   | 1,447  |  
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|Total current liabilities                                                                                                                                                                                             |  | $                  | 3,875  |   |                   | $ | 4,849  |  
|Commitments and contingencies                                                                                                                                                                                         |  |                    |        |   |                   |   |        |  
|Stockholders equity:                                                                                                                                                                                                 |  |                    |        |   |                   |   |        |  
|Common stock, $0 par value; 100,000 and 50,000 shares authorized at March 31, 2006 and June 30, 2005, respectively; 20,678 and
19,799 shares issued and outstanding at March 31, 2006 and June 30, 2005, respectively |  |                    | 71,656 |   |                   |   | 70,296 |  
|Deferred compensation                                                                                                                                                                                                 |  |                    |       |   |                   |   | (545   | )
|Accumulated comprehensive loss                                                                                                                                                                                        |  |                    | (103   | ) |                   |   | (24    | )
|Accumulated deficit                                                                                                                                                                                                   |  |                    | (6,237 | ) |                   |   | (5,331 | )
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|Total stockholders equity                                                                                                                                                                                            |  |                    | 65,316 |   |                   |   | 64,396 |  
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  
|Total liabilities and stockholders equity                                                                                                                                                                            |  | $                  | 69,191 |   |                   | $ | 69,245 |  
|                                                                                                                                                                                                                      |  |                    |        |   |                   |   |        |  

See accompanying notes



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CALLWAVE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)



|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------ |  | ---------------------------------- | ------ | - | ---------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                           |  | For the Three Months EndedMarch 31 |        |   | For the Nine Months EndedMarch 31, |  
|                                           |  | 2006                               |        |   | 2005                               |   |        | 2006 |  |   | 2005   |  
|Revenues                                   |  | $                                  | 8,801  |   |                                    | $ | 11,194 |      |  | $ | 28,910 |   |  | $ | 33,908 |  
|Cost of sales                              |  |                                    | 3,125  |   |                                    |   | 3,017  |      |  |   | 10,275 |   |  |   | 9,160  |  
|Gross profit                               |  |                                    | 5,676  |   |                                    |   | 8,177  |      |  |   | 18,635 |   |  |   | 24,748 |  
|Operating expenses:                        |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Sales and marketing                        |  |                                    | 2,270  |   |                                    |   | 2,748  |      |  |   | 6,406  |   |  |   | 7,722  |  
|Research and development                   |  |                                    | 1,371  |   |                                    |   | 1,778  |      |  |   | 3,865  |   |  |   | 5,054  |  
|General and administrative                 |  |                                    | 2,959  |   |                                    |   | 2,070  |      |  |   | 7,683  |   |  |   | 5,151  |  
|Impairment of long-lived assets            |  |                                    |       |   |                                    |   |       |      |  |   | 243    |   |  |   |       |  
|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                   |  |                                    | 6,600  |   |                                    |   | 6,596  |      |  |   | 18,197 |   |  |   | 17,927 |  
|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Operating income (loss)                    |  |                                    | (924   | ) |                                    |   | 1,581  |      |  |   | 438    |   |  |   | 6,821  |  
|Interest income (expense), net             |  |                                    | 659    |   |                                    |   | 344    |      |  |   | 1,741  |   |  |   | 661    |  
|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) before income taxes          |  |                                    | (265   | ) |                                    |   | 1,925  |      |  |   | 2,179  |   |  |   | 7,482  |  
|Income tax expense (benefit)               |  |                                    | 156    |   |                                    |   | (347   | )    |  |   | 3,085  |   |  |   | (2,056 | )
|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                          |  | $                                  | (421   | ) |                                    | $ | 2,272  |      |  | $ | (906   | ) |  | $ | 9,538  |  
|                                           |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) per share:               |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Basic                                      |  | $                                  | (0.02  | ) |                                    | $ | 0.12   |      |  | $ | (0.04  | ) |  | $ | 0.63   |  
|Diluted                                    |  | $                                  | (0.02  | ) |                                    | $ | 0.11   |      |  | $ | (0.04  | ) |  | $ | 0.48   |  
|Weighted average common shares outstanding |  |                                    |        |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Basic                                      |  |                                    | 20,746 |   |                                    |   | 19,377 |      |  |   | 20,578 |   |  |   | 15,033 |  
|Diluted                                    |  |                                    | 21,406 |   |                                    |   | 21,331 |      |  |   | 21,287 |   |  |   | 20,026 |  

See accompanying notes.



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CALLWAVE, INC

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                         |  |                            |         |   |      |   |         |  
|---------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                         |  | Nine Months EndedMarch 31, |        
|                                                                                         |  | 2006                       |         |   | 2005 |  
|Cash flows from operating activities:                                                    |  |                            |         |   |      |   |         |  
|Net income (loss)                                                                        |  | $                          | (906    | ) |      | $ | 9,538   |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                            |         |   |      |   |         |  
|Depreciation and amortization                                                            |  |                            | 628     |   |      |   | 566     |  
|Impairment of long-lived assets                                                          |  |                            | 253     |   |      |   |        |  
|Amortization of deferred compensation                                                    |  |                            | 290     |   |      |   | 185     |  
|Non-employee equity based compensation                                                   |  |                            |        |   |      |   | 11      |  
|Deferred tax asset                                                                       |  |                            | 2,929   |   |      |   | (1,536  | )
|Inventory write off                                                                      |  |                            | 314     |   |      |   |        |  
|Bad debt expense                                                                         |  |                            | 1,470   |   |      |   | 929     |  
|Changes in operating assets and liabilities:                                             |  |                            |         |   |      |   |         |  
|Restricted Cash                                                                          |  |                            | 336     |   |      |   |        |  
|Accounts receivable, net of bad debt expense                                             |  |                            | 387     |   |      |   | (2,511  | )
|Inventory                                                                                |  |                            | 140     |   |      |   | (586    | )
|Prepaid income tax                                                                       |  |                            | (67     | ) |      |   | (113    | )
|Other assets                                                                             |  |                            | 317     |   |      |   | (152    | )
|Accounts payable                                                                         |  |                            | 38      |   |      |   | (584    | )
|Accrued payroll                                                                          |  |                            | (189    | ) |      |   | 42      |  
|Deferred revenues                                                                        |  |                            | (1,300  | ) |      |   | (793    | )
|Accrued other liabilities                                                                |  |                            | 479     |   |      |   | 499     |  
|Income Tax Payable                                                                       |  |                            |        |   |      |   | (750    | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by operating activities                                                |  |                            | 5,119   |   |      |   | 4,745   |  
|Cash flows from investing activities:                                                    |  |                            |         |   |      |   |         |  
|Purchase of Intangible Assets                                                            |  |                            | (550    | ) |      |   |        |  
|Purchases of marketable securities                                                       |  |                            | (25,575 | ) |      |   | (33,893 | )
|Sales of marketable securities                                                           |  |                            | 23,790  |   |      |   |        |  
|Purchases of property and equipment                                                      |  |                            | (373    | ) |      |   | (546    | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                      |  |                            | (2,708  | ) |      |   | (34,439 | )
|Cash flows from financing activities:                                                    |  |                            |         |   |      |   |         |  
|Exercises of stock options and warrants                                                  |  |                            | 1,361   |   |      |   | 1,398   |  
|Proceeds from initial public offering                                                    |  |                            |        |   |      |   | 37,200  |  
|Costs incurred in initial public offering                                                |  |                            |        |   |      |   | (1,975  | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by financing activities                                                |  |                            | 1,361   |   |      |   | 36,623  |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                |  |                            | 3,772   |   |      |   | 6,929   |  
|Cash and cash equivalents at beginning of the period                                     |  |                            | 16,828  |   |      |   | 6,187   |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Cash and cash equivalents at end of the period                                           |  | $                          | 20,600  |   |      | $ | 13,116  |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Supplemental disclosures of cash flow information                                        |  |                            |         |   |      |   |         |  
|Cash paid for Income taxes                                                               |  |                            |        |   |      |   | 343     |  
|Supplemental schedule of non-cash transactions                                           |  |                            |         |   |      |   |         |  
|Equity based deferred compensation                                                       |  | $                          | 545     |   |      | $ | 493     |  

See accompanying notes.



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CallWave Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. The Company and Basis of
Presentation

Description of businessCallWave, Inc. (CallWave, or the Company), was incorporated in August 1998, first marketed its free
services in February 1999 and began marketing paid subscription services in April 2001. CallWave provides software-based communications application services that bridge calls across existing landline, mobile and Internet networks.

Basis of PresentationThe accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial
statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Companys financial position, results of operations and cash flows for the periods shown.
The results of operations for such periods are not necessarily indicative of the results expected for a full year or for any future period.

These
financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Companys year end financial statements included in the Form 10-K filed with the Securities and Exchange Commission.

Use of estimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States
necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. The primary accounts that are particularly sensitive to changes in estimates are the allowance for doubtful accounts, inventory allowance, net realizable value of investments and the valuation
allowance for the deferred tax asset. Actual results could differ from those estimates.

Revenue recognitionThe Company earns revenues from
paid subscriber services, and to a lesser extent, fees earned from local exchange carrier call termination access charges, advertisements and the offering of third-party products and services to our subscribers. Beginning in fiscal year 2005, the
Company entered the prepaid mobile phone market by selling prepaid phones to a distributor and on a subsidized basis directly to its subscriber.

The
Company recognizes revenue in accordance with accounting principles generally accepted in the United States and with Securities and Exchange Commission Staff Accounting Bulletin 104 (SAB 104),Revenue Recognition, which clarifies certain
existing accounting principles for the timing of revenue recognition and classification of revenues in the financial statements. The Company recognizes revenue ratably beginning when there is persuasive evidence of an arrangement, delivery has
occurred or services have been rendered, the fees are fixed and determinable and collection is reasonably assured. Install fees are recorded as deferred revenues and amortized to revenue over the expected period of performance, or the estimated
average customer subscription life.

In addition to the direct relationship that the Company has with the majority of its paid subscribers, the Company
also has channel relationship agreements with Internet service providers (ISPs), telephone service providers and other companies whereby those companies customers are offered a co-branded subscription service. When the agreement provides that
the Company is the party responsible for providing the service, has control over the fees charged to customers and bears the credit risk, the Company records the gross amount billed as revenue in accordance with Emerging Issues Task Force 99-19
(EITF 99-19),Reporting Revenues Gross as a Principal Versus Net as an Agent. When the agreement provides that CallWave receive a net payment from those companies, based upon the number of their customers registered for CallWaves
services, CallWave records the net amount received from those companies as revenue in accordance with EITF 99-19.

In the third quarter of fiscal 2005, the
Company purchased prepaid phones and phone cards with the intention of reselling them with a 30-day free trial of CallWaves application-based services and entered into an agreement to sell a portion of these prepaid phones and phone cards to a
distributor. Revenue from the sale of prepaid phones and phone cards is recognized when the SAB 104 criteria are met. The Company recognizes sales to this distributor on a sell-through basis and when the cash is collected from the distributor. The
Company recognized $225,000 of revenue related to the sale to this distributor in the nine months ended March 31, 2006.

Beginning in the fourth
quarter of fiscal 2005, the Company began selling prepaid phones into which the CallWave technology is embedded to its subscriber base. These transactions contain multiple elements, including the phone, the minutes, and our CallWave service, to
which we have applied EITF 00-21,Revenue Arrangements with Multiple Deliverables. The various elements of the



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arrangement are separable and each element is recognized separately in accordance with SAB 104. In accounting for
multiple deliverables, managements judgment is necessary when identifying the nature of deliverables in an arrangement as well as measuring and allocating fair value to the multiple deliverables.

In the second quarter of fiscal 2006, the Company changed its marketing strategy for the CallWave for Mobile services to give prepaid cell phones to customers at no cost
if they signed up for a one month trial subscription to CallWave services and reimbursed the Companys shipping and handling costs. The phones are recorded as cost of sales to generate subscription services revenue in accordance with EITF
01-9,Accounting for Consideration Given by a Vendor to a Customer. The reimbursement of shipping and handling costs is recorded as an offset to cost of sales.

Deferred revenueDeferred revenue consists of customer prepayments of subscription fees, which will be earned in the future under agreements existing at the balance sheet date. Deferred revenue is
amortized ratably over the period in which services are provided.

Marketable securitiesMarketable securities consist of investment grade
government agency and corporate debt securities due within one year. Investments with maturities beyond one year are classified as short-term based on their highly liquid nature and because such investments represent the investment of cash that is
available for current operations. All investments are classified as available-for-sale and are recorded at market value. Unrealized gains and losses are reflected in other comprehensive income.

Comprehensive income (loss): Comprehensive net income (loss) was ($985,000) and $9,492,000 for the nine months ended March 31, 2006 and 2005, respectively.
The comprehensive net income differs from the net income by the net unrealized gain or loss on short-term investments.

Inventories: Inventories
consist of finished goods and are stated at the lower of cost or market, cost being determined under the first-in, first-out method. Inventory at March 31, 2006 and June 30, 2005 consisted of the following:



|                          |  |               |         |   |              |   |         |  
|------------------------- |  | ------------- | ------- | - | ------------ | - | ------- | -
|                          |  | March 31,2006 |         |   | June 30,2005 |  
|CallWave inventory        |  | $             |        |   |              | $ | 243,000 |  
|Inventory at distributors |  |               | 60,000  |   |              |   | 286,000 |  
|Valuation Allowance       |  |               | (60,000 | ) |              |   | (75,000 | )
|                          |  |               |         |   |              |   |         |  
|Total inventory           |  | $             |        |   |              | $ | 454,000 |  
|                          |  |               |         |   |              |   |         |  

At June 30, 2005, CallWave inventory consisted of prepaid cell phones and phone cards that the Company held
for sale. The value of the phone cards was determined to be impaired in the quarter ended September 30, 2005, and reduced to net realizable value, or zero. Due to a change in marketing strategy, the phones are now given to customers at no cost
if they register for a one month trial subscription to CallWave services and reimburse the Companys shipping and handling costs. As the phones are no longer held for sale, they are not recorded as inventory, but are expensed as purchased.

Inventory at distributors represents phone cards sold to distributors accounted for on the sell-through basis which are fully reserved since the
distributor has not sold them through to its customers. Managements judgment is required in determining net realizable value and the extent of any impairment to our inventory. Judgment is also required in determining the collectibility of
amounts that are due from our distributors as a result of selling our inventory through to end customers.

Concentrations of credit riskThe
Company has a concentration of credit risk from an agreement with a vendor for billing and collection services provided for a portion of the Companys paid users. The Company would be subject to sustaining a loss relative to its current
receivable balance if the vendor failed to perform under the terms of the agreement. The receivable from the vendor at March 31, 2006 and June 30, 2005 was $3,626,000 and $5,517,000, respectively.

The Companys cash balances at financial institutions exceed the maximum amounts insured by the Federal Deposit Insurance Corporation.

Intangible assets  In March, 2006, the Company entered into a license agreements with Web Telephony, Inc., to use certain patent rights for $0.5 million in
cash. The license payment was allocated to intangible assets. In January, 2006 the Company entered into a license agreement with an independent software company to use certain software programs and related intellectual property in CallWaves
products. The Company will amortize the cost of these intangible assets on a straight-line basis over the life of the licenses.



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Investments in minority owned companiesThe Company accounts for investments in minority interests of
other companies over which it does not exercise significant influence on the cost method in accordance withSFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Under the cost method, an investment is
carried at cost until it is sold or there is evidence that changes in the business environment or other facts and circumstances suggest it may be other than temporarily impaired based on criteria outlined in FAS Staff Position Nos. FAS 115-1 and FAS
124-1 and on EITF Issue No. 03-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.

Share-Based
CompensationThe Company adopted FAS 123(R),Share-Based Payment, using the modified-prospective-transition-method as of July 1, 2005. Historically, the Company elected to account for employee stock compensation under the fair
value method in accordance with SFAS 123,Accounting for Stock-Based Compensation, and had reflected compensation expense related to the fair value of options issued to employees in the statement of operations. See further discussion in Note
4.

Income taxesIncome taxes are recorded in accordance with SFAS 109,Accounting for Income Taxes. SFAS 109 requires the recognition
of deferred tax assets and liabilities to reflect the future tax consequences of events that have been recognized in the Companys financial statements or tax returns. Measurement of the deferred items is based on enacted tax laws. In the event
the future consequences of differences between financial reporting bases and tax bases of the Companys assets and liabilities result in a deferred tax asset, SFAS 109 requires an evaluation of the probability of being able to realize the
future benefits indicated by such assets. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Net income (loss) per shareThe Company computes net income (loss) per share in accordance with SFAS 128,Earnings per Share. Under the provisions of
SFAS 128, basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and, if dilutive,
potential common shares outstanding during the period. Potential common shares consist of shares issuable upon exercise of stock options and warrants and conversion of convertible preferred stock. The dilutive effect of outstanding stock options and
warrants is reflected in diluted income per share by application of the treasury stock method. As of July 1, 2005, the date the Company adopted FAS 123(R), deferred compensation related to unvested outstanding options is included as a component
of proceeds upon exercise in calculation of the diluted shares under the treasury stock method. Convertible preferred stock is reflected on an if-converted basis.

For the three and nine month periods ended March 31, 2006, potential common shares resulting from outstanding options and warrants were not included in the diluted earnings per share calculation as their inclusion would be
anti-dilutive.

The following table sets forth the computation of basic and diluted net income per share:



|                                                                   |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|------------------------------------------------------------------ |  | ----------------------------------------------- | ------ | -------------------------- | ---- | - | ------ |  | - | ------ | - |  | - | ------
|                                                                   |  | Three Months EndedMarch 31,                     |        | Nine Months EndedMarch 31,
|                                                                   |  | 2006                                            |        |                            | 2005 |   | 2006   |  |   | 2005  
|                                                                   |  | (unaudited, in thousands except per share data)
|Basic and diluted net income (loss) per share:                     |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Net income (loss) attributable to common stockholders              |  | $                                               | (421   | )                          |      | $ | 2,272  |  | $ | (906   | ) |  | $ | 9,538 
|                                                                   |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Weighted-average common shares outstanding                         |  |                                                 | 20,746 |                            |      |   | 19,377 |  |   | 20,578 |   |  |   | 15,033
|Effect of dilutive securities:                                     |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Stock options and warrants                                         |  |                                                 |       |                            |      |   | 1,954  |  |   |       |   |  |   | 2,177 
|Convertible preferred shares                                       |  |                                                 |       |                            |      |   |       |  |   |       |   |  |   | 2,816 
|                                                                   |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Weighted-average common shares outstanding for diluted calculation |  |                                                 | 20,746 |                            |      |   | 21,331 |  |   | 20,578 |   |  |   | 20,026
|                                                                   |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Net income (loss) per share:                                       |  |                                                 |        |                            |      |   |        |  |   |        |   |  |   |       
|Basic                                                              |  | $                                               | (0.02  | )                          |      | $ | 0.12   |  | $ | (0.04  | ) |  | $ | 0.63  
|Diluted                                                            |  | $                                               | (0.02  | )                          |      | $ | 0.11   |  | $ | (0.04  | ) |  | $ | 0.48  

Options to purchase 508,276 and 292,000 shares with exercise prices equal to or greater than the average fair
value of common stock were outstanding during the nine months ended March 31, 2006 and 2005, respectively. These options were also excluded from the respective computations of diluted earnings per share because their effect would be
anti-dilutive.



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2. Related Party Transactions

In February 2004, the Company entered into an agreement with Insight Venture Management, LLC, an affiliate of Insight Venture Associates IV, LLC, a shareholder of the Company, to make available to it certain of Insights business
development personnel to assist the Company with market assessment, research and analysis. Under the terms of this agreement, the Company paid Insight $75,000 per year, payable in four quarterly installments at the end of each calendar quarter. The
price paid in this transaction was determined by considering the market rate for business development personnel possessing similar skills and experience. The Company terminated this agreement in February 2005.

3. Stockholders Equity

Common Stock

As of March 31, 2006, the Company is authorized to issue 100,000,000 shares of common stock. As of March 31, 2006, 2,399,000 shares of common stock are reserved
for the 120,000 warrants and 2,168,000 stock options issued and outstanding.

The Companys board of directors has the authority without further
action by the stockholders, to issue up to 10,000,000 shares of preferred stock in one or more series, to establish from time to time the number of shares to be included in each such series, to fix the rights, preferences and privileges of the
shares of each wholly unissued series and any qualifications, limitations or restrictions thereon, and to increase or decrease the number of shares of any such series (but below the number of shares of such series then outstanding).

Warrants

As of March 31, 2006, the Company has issued and
outstanding warrants to purchase up to 120,000 shares of common stock at exercise prices of between $0.55 - $4.00. The Company had 293,000 warrants issued and outstanding at June 30, 2005, and 173,000 warrants were exercised during the nine
months ended March 31, 2006.

4. Share-Based Payments

FAS 123(R) Adoption

At March 31, 2006 the Company has three stock-based employee compensation plans which are described more
fully below. Prior to July 1, 2005, the Company accounted for those plans under the recognition and measurement provisions of FASB Statement No. 123,Accounting for Stock-Based Compensation. Effective July 1, 2005, the Company
adopted the fair value recognition provisions of FASB Statement No. 123(R),Share-Based Payment, using the modified-prospective-transition method. Under that transition method, compensation cost recognized in the three months ended
September 30, 2005 includes the compensation expense that had been recognized under FAS 123 reduced by the amount of (a) estimated forfeitures related to the share-based payments granted prior to, but not yet vested as of July 1,
2005, and (b) estimated forfeitures for all share based payments granted subsequent to July 1, 2005. Results for prior periods have not been restated.

As a result of adopting FAS 123(R) on July 1, 2005, the Companys income (loss) before income taxes and net income (loss) for the three and nine months ended March 31, 2006, are $57,000 and $100,000, respectively, higher than
if it had continued to account for forfeitures as they occurred which was permissible under FAS 123 but not under FAS 123(R).

FAS 123(R) requires
companies to record as paid-in-capital, any tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) unless the company has net operating losses. In accordance with FAS 123(R)
guidance regarding companies with net operating losses, the Company will not record any excess tax benefits until the deduction actually reduce taxes payable.

Stock Option Plans

At March 31, 2006, the Company has three share-based compensation plans, which are described below.
Compensation cost that has been charged to expense for those plans was $81,000 and $71,000 for the three months ended March 31, 2006 and 2005, respectively.

The Companys stock option plans consist of the 2004 Option Plan, the 2000 Option Plan and the 1999 Option Plan. Shares reserved under these plans at March 31, 2006, consist of 1,700,000 shares, 2,250,000 shares and 1,350,000
shares authorized of which 874,807, 977,036 and 316,570 options are outstanding under the 2004, 2000 and 1999 Option Plans, respectively.



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##### Table of Contents

The Companys board of directors grants options at an exercise price equal to the fair market value of the
Companys common stock at the date on which the grant is approved by the board. Stock options granted prior to the Companys initial public offering had a term of ten years from the date on which the grant is approved by the board. Options
granted subsequent to the Companys initial public offering have a term of five years. Generally, stock options vest 1/8th after six months, and 1/48th per month thereafter, becoming fully vested in four years. The weighted-average fair
value of stock options granted is estimated at the date of grant using the Black-Scholes option pricing model and the following assumptions:



|                                                     |  |                             |      |   |                            |   |      |      |  |   |      |   |  |   |      |  
|---------------------------------------------------- |  | --------------------------- | ---- | - | -------------------------- | - | ---- | ---- |  | - | ---- | - |  | - | ---- | -
|                                                     |  | Three Months EndedMarch 31, |      |   | Nine-Months EndedMarch 31, |  
|                                                     |  | 2006                        |      |   | 2005                       |   |      | 2006 |  |   | 2005 |  
|Weighted average fair value of stock options granted |  | $                           | 4.73 |   |                            | $ | 5.49 |      |  | $ | 4.47 |   |  | $ | 1.89 |  
|Risk free interest rate                              |  |                             | 4.60 | % |                            |   | 4.22 | %    |  |   | 3.89 | % |  |   | 4.27 | %
|Expected life (in years)                             |  |                             | 4.0  |   |                            |   | 4.0  |      |  |   | 4.0  |   |  |   | 4.0  |  
|Expected volatility                                  |  |                             | 50.0 | % |                            |   | 50.0 | %    |  |   | 50.0 | % |  |   | 4.92 | %
|Expected dividend yield                              |  |                             | 0.00 | % |                            |   | 0.00 | %    |  |   | 0.00 | % |  |   | 0.00 | %

Expected volatilities are based on the historical volatility of the Companys stock and other factors. The
Company uses historical data to estimate option exercise and employee termination within the model. Separate groups of options with similar pricing are considered separately for valuation purposes. The expected term of options granted represents the
period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury rate in effect at the time of the grant.

A summary of option activity under the plans as of March 31, 2006, and changes during the quarter and nine months then ended is presented below:



|                              |  |                  |   |  |                                |      |                                    |      |                         |   |          
|----------------------------- |  | ---------------- | - |  | ------------------------------ | ---- | ---------------------------------- | ---- | ----------------------- | - | ---------
|                              |  | Number of Shares |   |  | Weighted-Average ExercisePrice |      | Weighted- Average Contractual Term |      | AggregateIntrinsicValue
|Balance June 30, 2005         |  | 2,502,189        |   |  | $                              | 3.48 |                                    |      |                         |   |          
|Options granted               |  | 672,826          |   |  |                                | 4.45 |                                    |      |                         |   |          
|Options exercised             |  | (669,682         | ) |  |                                | 1.66 |                                    |      |                         |   |          
|Options forfeited or expired  |  | (226,460         | ) |  |                                | 7.77 |                                    |      |                         |   |          
|                              |  |                  |   |  |                                |      |                                    |      |                         |   |          
|Balance December 31, 2005     |  | 2,278,873        |   |  | $                              | 3.88 |                                    |      |                         |   |          
|Options granted               |  | 39,000           |   |  |                                | 4.73 |                                    |      |                         |   |          
|Options exercised             |  | (48,488          | ) |  |                                | 1.66 |                                    |      |                         |   |          
|Options forfeited or expired  |  | (88,081          | ) |  |                                | 9.33 |                                    |      |                         |   |          
|                              |  |                  |   |  |                                |      |                                    |      |                         |   |          
|Balance March 31, 2006        |  | 2,181,304        |   |  | $                              | 3.72 |                                    | 5.40 |                         | $ | 2,874,965
|                              |  |                  |   |  |                                |      |                                    |      |                         |   |          
|Exercisable at March 31, 2006 |  | 1,186,028        |   |  | $                              | 2.96 |                                    | 5.49 |                         | $ | 1,933,002
|                              |  |                  |   |  |                                |      |                                    |      |                         |   |          

The total intrinsic value of options exercised during the nine months ended March 31, 2006 and 2005 was
$111,145 and $107,303, respectively.



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##### Table of Contents

A summary of the status of the Companys nonvested shares as of March 31, 2006 and changes during the nine
month period ended March 31, 2006, is presented below:



|                               |  |           |   |  |                                      |     
|------------------------------ |  | --------- | - |  | ------------------------------------ | ----
|                               |  | Shares    |   |  | Weighted-AverageGrant-Date FairValue
|Nonvested Shares               |  |           |   |  |                                      |     
|Nonvested at July 1, 2005      |  | 828,737   |   |  | $                                    | 1.36
|Granted                        |  | 672,826   |   |  |                                      | 1.94
|Vested                         |  | (197,820  | ) |  |                                      | 1.27
|Forfeited                      |  | (224,239  | ) |  |                                      | 1.64
|                               |  |           |   |  |                                      |     
|Nonvested at December 31, 2005 |  | 1,079,504 |   |  | $                                    | 1.17
|Granted                        |  | 39,000    |   |  |                                      | 4.73
|Vested                         |  | (112,670  | ) |  |                                      | 2.50
|Forfeited                      |  | (11,895   | ) |  |                                      | 5.75
|                               |  |           |   |  |                                      |     
|Nonvested at March 31, 2006    |  | 993,939   |   |  | $                                    | 1.10
|                               |  |           |   |  |                                      |     

As of March 31, 2006, there was $1.7 million of total unrecognized compensation cost related to nonvested
share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted-average period of 2.1 years. The total fair value of shares vested during the nine months ended March 31, 2006 was $532,906.

5. Investment in Minority Owned Company

On
January 6, 2005, the Company acquired a minority interest in a UK company (the investee) for $125,000 which was recorded on the cost method of accounting for investments in accordance with SFAS No. 115,Accounting for Certain
Investments in Debt and Equity Securities. Additionally, the investee issued to the Company a $125,000 promissory note due January 6, 2011. The promissory note is convertible into common stock in certain circumstances and bears interest at
4% per year, compounded monthly. The Company also purchased a license to the investees technology for five years for $125,000, which was amortized to expense over the life of the license. A total of $375,000 was recorded as Other Assets.
At September 30, 2005, the Company determined that the investment in and receivable from the investee was other than temporarily impaired and recorded an impairment loss in the amount of $253,000. This impairment loss was partially offset by a
gain of $10,000 on the sale of an asset that had been previously written off. At December 31, 2005, the Company wrote off the remaining unamortized cost of the license in the amount of $106,000 to research and development expense as it decided
not to pursue use of the license.

6. Commitments and Contingencies

Leases

The Company leases office space under non-cancelable operating leases. Rental expense under operating lease
agreements was $157,000 and $118,000 for the three months ended March 31, 2006 and 2005, respectively, and $355,000 and $355,000 for the nine months ended March 31, 2006 and 2005, respectively.

Future minimum commitments remaining under these agreements as of March 31, 2006, are as follows:



|                            |  |                   |    
|--------------------------- |  | ----------------- | ---
|                            |  | MinimumCommitment
|                            |  | (in thousands)   
|Fiscal Year Ending June 30: |  |                   |    
|2006                        |  | $                 | 185
|2007                        |  |                   | 759
|2008                        |  |                   | 746
|2009                        |  |                   | 530
|2010                        |  |                   | 531
|2011                        |  |                   | 44 



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Other Commitments and Contingencies

The Company has long-distance service agreements with four carriers. As of March 31, 2006, minimum obligations under these agreements due within one year total $1.5 million. However, the Company expects to
maintain some form of long-distance service agreements indefinitely, and will likely assume similar obligations following the expiration of these agreements. As of March 31, 2006, minimum obligations due within one year under agreements with
providers of billing and collection services total $119,000.

The Company and its subsidiaries are subject to certain claims and may encounter future legal
claims in the normal course of business. In the opinion of the Companys management, the resolution of existing legal claims are not expected to have a material adverse impact on the Companys financial position, results of operations or
cash flows. See Note 8 for additional discussion of litigation.

7. Income Taxes

The provision for income taxes consists of the following for each of the periods ended:



|                          |  |                            |     |      |                            |       |      |  |      |       |  |   |        |  
|------------------------- |  | -------------------------- | --- | ---- | -------------------------- | ----- | ---- |  | ---- | ----- |  | - | ------ | -
|                          |  | Three Months EndedMarch 31 |     |      | Nine Months EndedMarch 31, |      
|                          |  | 2006                       |     | 2005 |                            |       | 2006 |  | 2005 |      
|Current federal provision |  | $                          | 103 |      | $                          | (100  | )    |  | $    | 102   |  | $ | 442    |  
|Current state             |  |                            | 53  |      |                            | (100  | )    |  |      | 54    |  |   | 68     |  
|Deferred (benefit)        |  |                            |    |      |                            | (147  | )    |  |      | 2,929 |  |   | (2,566 | )
|                          |  |                            |     |      |                            |       |      |  |      |       |  |   |        |  
|                          |  | $                          | 156 |      | $                          | $(347 | )    |  | $    | 3,085 |  | $ | (2,056 | )
|                          |  |                            |     |      |                            |       |      |  |      |       |  |   |        |  

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not
that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which temporary differences and net operating losses
become deductible and tax credits become usable. Use of net operating loss and other carry forwards are limited by the change of ownership rules described below. Due to the uncertainty surrounding the timing of realizing the benefits of
its NOLs and other favorable tax attributes in future tax returns, the Company has placed a valuation allowance against its otherwise recognizable deferred tax assets. The valuation allowance increased by approximately $129,000 during the quarter
ended March 31, 2006.

As of March 31, 2006, the Company has cumulative net operating loss carryforwards for federal and California income tax
purposes of approximately $4.3 million and $15.7 million, respectively. The losses begin to expire in fiscal year 2009 if unused. In addition, the Company has available tax credit carryforwards of approximately $1.4 million and $0.5 million for
federal and California tax purposes, respectively. The federal tax credits begin to expire in 2028. California tax credits can be carried over indefinitely.

Due to the change of ownership provision of the Tax Reform Act of 1986, utilization of the Companys net operating loss and tax credit carryforwards are subject to an annual limitation against taxable income in future
periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities. In addition, the Company is preparing an analysis of the change of ownership
provision on its California state operating loss carryforwards. Management believes that such analysis may result in the recording of an additional deferred tax asset with a corresponding valuation allowance subject to the realization analysis
discussed above.

On September 11, 2002, the Governor of California signed into law new tax legislation that suspended the use of California net
operating loss carryforwards in the Companys tax years ending June 30, 2003 and 2004. As a result, the Company cannot use its California net operating loss carryforwards to offset its taxable income for the years ended June 30, 2003
and 2004. The Company eliminated its California tax using tax credit carryforwards for both periods. This suspension will not apply to the Companys tax years ending June 30, 2005, and beyond.

8.Litigation

On August 24, 2004, j2 Global
Communications, Inc., or j2, filed a complaint against the Company in the United States District Court for the Central District of California alleging that the Companys operations infringe U. S. Patent No. 6,350,066, or the `066 patent.
j2s complaint seeks unspecified damages and permanent injunctive relief, among other relief. On September 14, 2004, the Company filed its response to the complaint, denying the allegations of the complaint and alleging affirmative
defenses to the complaint. On



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##### Table of Contents

December 30, 2004, j2 filed a first amended complaint, alleging that in addition to infringing the 066 patent,
the Company infringes U. S. Patent Nos. 6,564,321, or the `321 patent, and 6,208,638, or the `638 patent. On January 31, 2005, the Company filed its response to the first amended complaint, denying the allegations of the complaint and alleging
affirmative defenses to the complaint. On April 21, 2005, j2 filed a second amended complaint, alleging that the Company infringes the claims of U.S. Patent No. 6,857,074, or the `074 patent. On May 10, 2005, the Company filed its
response to the second amended complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On December 15, 2005, a Markman hearing was held in the case. Before any order issued from that hearing,
however, on January 11, 2006, the Court stayed the action pending reexamination of some of the patents in the United States Patent and Trademark Office, or USTPO. It is unclear what the duration of that stay will be. The Companys
intellectual property counsel has provided to the Company opinions that the Company does not infringe the claims of the asserted patents. By reason of those opinions, the Company does not believe that it infringes the claims of those patents.
However, if the USPTO affirms the validity of the patents and trial resumes, then the Companys efforts to defend against j2s assertions will be expensive and time-consuming.

The Company in October 2004 received a letter from counsel to Web Telephony, LLC, or Web Telephony, implying that our operations infringe certain claims in U.S. Patent No. 6,445,694, Internet Controlled
Telephone System, or the `694 patent, and U.S. Patent No. 6,785,266, Internet Controlled Telephone System, or the `266 patent. On January 19, 2005, the Company filed in the United States District Court for the Central
District of California an action for declaratory relief, in which the Company sought to have the court declare that the Company does not infringe the `694 patent or the `266 patent. Web Telephony subsequently counterclaimed, alleging infringement of
the `694 and `266 patents. Effective March 28, 2006, the Company and Web Telephony executed a definitive settlement agreement under which the parties waived all claims against each other with respect to the 694 and the 266 patents,
and Web Telephone granted to the Company a worldwide, fully paid-up, nonexclusive license entitling the Company to practice the claims of the 694 and the 266 patents. The parties, by stipulation, subsequently dismissed the litigation.

On July 1, 2005, Catch Curve, Inc., or Catch Curve, filed a complaint against the Company in the United States District Court for the Central
District of California, alleging that the Companys operations infringe U.S. Patents No. 6,785,021, or the `021 Patent, U.S. Patent No. 6,643,034, or the `034 Patent, U.S. Patent No. 5,291,302, or the `302 Patent, and U.S. Patent
No. 4,994,926, or the `926 Patent. The Company thereafter filed its answer, denying the allegations and asserting certain counterclaims and affirmative defenses. Catch Curve thereafter filed its answer to those counterclaims, denying the
Companys allegations. A trial date of October 2, 2007, has been set in this case. The Company has received from intellectual property counsel opinions that the Companys present operations do not infringe the claims of the `021
patent, the `034 patent, the `302 patent, or the `926 patent. By reason thereof, we presently do not believe it is probable that we will suffer, by reason of such litigation, a material loss. However, it is premature to reach any definitive
conclusions in that regard.

In the event of an adverse result in the j2 litigation, the Catch Curve litigation, or in any other litigation between the
Company and third parties that may arise in the future with respect to intellectual property rights relevant to the Companys services, the Company could be required to pay substantial damages, including treble damages if a court determines
that the Company has willfully infringed a third partys patent rights, to cease the use and sale of infringing services, to expend significant resources to develop non-infringing technology, or to obtain licenses to the infringing technology.
The Company cannot be certain that licenses will be available on commercially reasonable terms, or at all, from j2 or Catch Curve, or any third party that has such intellectual property claims against us. In addition, litigation frequently involves
substantial expenditures and can require significant management attention even if the Company ultimately prevails. Accordingly, the Company cannot predict whether the j2 litigation or the Catch Curve litigation will have a material adverse effect on
the Companys business, operating results, financial condition or cash flows. Due to the early stage of these two actions, and because neither j2 nor Catch Curve has sought specified damages, the Company cannot determine with precision the
outcome of the litigation or any costs or payments resulting from the litigation or the settlement of any of those actions. Accordingly, no provision for any loss which may result from the j2 litigation or the Catch Curve litigation has been
recorded in the accompanying financial statements. In addition, the Company and its subsidiary in the future may encounter legal claims in the normal course of business. In the opinion of the Company, the costs associated with the resolution of
existing legal claims cannot be precisely estimated at this time, and the Company has not yet determined whether such costs will have a material adverse impact on the Companys financial position, results of operations or cash flows.

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This section and
other parts of this Form 10-Q contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by words such as anticipates, expects, believes,
plans, predicts, and similar terms. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors
that might cause such differences include, but are not limited to, those discussed in the subsection entitled Risk Factors below. The following discussion should be read in conjunction with our Annual Report on Form 10-K filed
September 15, 2005, and the consolidated financial statements and notes thereto included elsewhere in this Form 10-Q. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.



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Overview

Historically, we have provided application services on a subscription basis that add features and enhanced functionality to the telecommunications services used by mainstream consumers and small and home offices. Our software-based services
are delivered on our proprietary Enhanced Services Platform, which allows subscribers to manage calls across existing landline, mobile and Internet networks. As of March 31, 2006, we had approximately 763,000 total subscribers for these
application services. Because our services improve the utilization of existing telecommunications services by our subscribers, we believe that our application services complement the efforts of landline, mobile and Internet service providers to
reduce their subscriber churn. This has allowed us to establish cooperative relationships with network service providers.

In the fourth quarter of fiscal
2005, we began test marketing a new mobile product that was officially launched in the first quarter of fiscal 2006. We provide mobile subscribers with subsidized cell phones in the first month of service. As of March 31, 2006, we had
approximately 10,000 paying subscribers for the mobile service. We account for the cell phones and fulfillment expenses as cost of sales which affects our gross margin.

In fiscal 2006, we are shifting our marketing strategy from directly marketing our services to consumers and small businesses to marketing our services to users through indirect distribution arrangements
in which we enter into agreements with telecommunications services providers, which agree to distribute our services to their subscribers. There typically is a long lead time prior to concluding agreements, including negotiations, implementation and
the time to market and persuade the customer to subscribe for our services. As we are reducing the amount of resources spent to market and distribute our services directly to users and will be making an investment in developing our indirect
distribution arrangements, we are forecasting six quarters of losses prior to returning to profitability.

Critical Accounting Policies and the Use of
Estimates

Revenue recognition. We earn revenues primarily from paid subscriber services and to a lesser extent, fees earned from local exchange
carrier call termination access charges and the offering of third-party products and services to our subscribers. Beginning in 2005, we entered the prepaid mobile phone market by selling prepaid phones directly to our subscriber base and to a
distributor. As of October 1, 2005, we stopped selling the phones and started to give the phones free of charge to customers who sign up for the CallWave for Mobile service and reimburse us for shipping and handling costs.

We recognize revenue in accordance with accounting principles generally accepted in the United States and with Securities and Exchange Commission Staff Accounting
Bulletin 104 (SAB 104),Revenue Recognition, which clarifies certain existing accounting principles for the timing of revenue recognition and classification of revenues in the financial statements, we recognize revenue beginning when there is
persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the fees are fixed and determinable and collection is reasonably assured. Our subscriber revenues consist of monthly recurring subscription fees. We
recognize revenue ratably over the subscription period when the SAB 104 criteria are met. We record install fees as deferred revenues and amortize them to revenue over the expected period of performance, or the average customer subscription life.

In addition to the direct relationship that we have with the majority of our paid subscribers, we also have indirect relationship agreements with Internet
service providers (ISPs) and other companies whereby those companies customers are offered a co-branded subscription service. When the agreement provides that we are the party responsible for providing the service, we have control over the
fees charged to customers and bear the credit risk, we record the gross amount billed as revenue in accordance with Emerging Issues Task Force 99-19 (EITF 99-19),Reporting Revenues Gross as a Principal Versus Net as an Agent. When the
agreement provides that we receive a net payment from those companies, based upon the number of their customers registered for our services, we record the net amount received from those companies as revenue in accordance with EITF 99-19.

In the third quarter of fiscal 2005, we purchased prepaid phones and phone cards with the intention of reselling them with a 30-day free trial of our
application-based services and entered into an agreement to sell the prepaid phones and a portion of the phone cards to a distributor. Revenue from the sale of prepaid phones and phone cards is recognized when the SAB 104 criteria are met. We
recognize sales to distributors on a sell-through basis when we collect the cash from the distributor.

In the fourth quarter of fiscal 2005, we began
selling prepaid phones embedded with our technology to our subscriber base. These transactions contain multiple elements, including the phone, the minutes, and our service, to which we have applied EITF 00-21,Revenue Arrangements with Multiple
Deliverables. The various elements of the arrangement are separable and each element is



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recognized separately in accordance with SAB 104. In accounting for multiple deliverables, managements judgment is
necessary when identifying the nature of deliverables in an arrangement as well as measuring and allocating fair value to the multiple deliverables.

In
the second quarter of fiscal 2006, we changed our marketing strategy for the CallWave for Mobile services to give prepaid cell phones to customers at no cost if they register for a one month trial subscription to CallWave services and reimburse our
shipping and handling costs. The phones are charged to cost of sales to generate subscription services revenue in accordance with EITF 01-9,Accounting for Consideration Given by a Vendor to a Customer. The reimbursement of shipping and
handling costs is recorded as an offset to cost of sales.

Allowances for Doubtful Accounts

We record an allowance for doubtful accounts based on our historical experience with bad debts. We periodically review and negotiate bad debt reserves held by the local
telephone companies and the third party that manages our billing relationship with the telephone companies. Judgment is required when we assess the realization of receivables, including assessing the probability of collection. Our allowance for
doubtful accounts totaled $315,000 as of March 31, 2006, approximately 15% less than the balance as of June 30, 2005. Our allowance for doubtful accounts is correlated with our aggregate billings through the local telephone companies.

Investments in minority owned companiesWe account for investments in minority interests of other companies over which we do not exercise
significant influence on the cost method in accordance withAccounting for Certain Investments in Debt and Equity Securities (SFAS 115). Under the cost method, an investment is carried at cost until it is sold or there is evidence that
changes in the business environment or other facts and circumstances suggest it may be other than temporarily impaired based on the criteria outlined in FAS Staff Position Nos. FAS 115-1 and FAS 124-1 and on EITF Issue No. 03-1,The Meaning
of Other-Than-Temporary Impairment and its Application to Certain Investments.

Inventories

Inventories consist of finished goods and are stated at the lower of cost or net realizable cost, cost being determined under the first-in, first-out method. As described
above, we changed our marketing strategy for the CallWave for Mobile services to give prepaid cell phones to customers at no cost if they register for a one month trial subscription and reimburse our shipping and handling costs. As we are no longer
selling these phones, they are not included in inventory. At March 31, 2006, the inventory balance approximates $60,000 and consists of phone cards sold to a distributor and accounted for on a sell-through basis. We have recorded an impairment
allowance against inventory in an equal amount as very few of these cards have been sold through to customers. Managements judgment is required in determining net realizable value and the extent of any impairment to our inventory. Judgment is
also required in determining the collectibility of amounts that are due from our distributors as a result of selling our inventory through to end customers.

Accounting for Income Taxes

We account for income taxes using the asset and liability method in accordance with SFAS 109,Accounting for Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of the assets and liabilities. At
March 31, 2006, we had deferred tax assets of $5.4 million. Due to the uncertainty of realizing these deferred tax assets, we have maintained a full valuation allowance as an offset against the deferred tax assets. Such uncertainty primarily
relates to the potential for future taxable income as well as the amount, limitation, and expiration of loss carryforwards and tax credits which begin expiring in 2009. In addition, pursuant to Sections 382 and 383 of the Internal Revenue Code,
annual use of our net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period. Management has determined that it is more likely than not that no deferred tax assets
will be realized within the 2006 and 2007 fiscal years. We will continue to assess the likelihood of realization of such assets. As future events and estimates change, we will adjust the valuation allowance pursuant to SFAS 109, if necessary, which
may impact the tax provision or equity or both.

Share-Based CompensationWe adopted FAS 123(R),Share-Based Payment, on July 1,
2005, using the modified- prospective-transition-method. Historically, we elected to account for employee stock compensation under the fair value method in accordance with SFAS 123,Accounting for Stock-Based Compensation, and had reflected
compensation expense related to the fair value of options issued to employees in the statement of operations. Under FAS 123(R), stock-based compensation is recorded based upon the fair value of the awards granted, using a Black-Scholes option
pricing model, which includes the fair value of the underlying shares on the date of grant, an estimate of the options to be forfeited and the exercise price. Adoption of FAS 123(R) had an immaterial impact on our financial statements as we
have been recording share-based compensation expense under FAS 123 since inception and as we have net operating loss carryforwards which prevent us from recognizing excess tax benefits until the excess tax benefits are used to offset income taxes
payable.



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Results of Operations

The following tables set forth our statement of operations data for each of the periods indicated.



|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------- |  | --------------------------- | ----- | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                |  | Three Months EndedMarch 31, |       |   | Nine Months EndedMarch 31, |  
|                                |  | 2006                        |       |   | 2005                       |   |        | 2006 |  |   | 2005   |  
|Statement of Operations Data:   |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Revenues                        |  | $                           | 8,801 |   |                            | $ | 11,194 |      |  | $ | 28,910 |   |  | $ | 33,908 |  
|Cost of sales                   |  |                             | 3,125 |   |                            |   | 3,017  |      |  |   | 10,275 |   |  |   | 9,160  |  
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                    |  |                             | 5,676 |   |                            |   | 8,177  |      |  |   | 18,635 |   |  |   | 24,748 |  
|Operating expenses:             |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Sales and marketing             |  |                             | 2,270 |   |                            |   | 2,748  |      |  |   | 6,406  |   |  |   | 7,722  |  
|Research and development        |  |                             | 1,371 |   |                            |   | 1,778  |      |  |   | 3,865  |   |  |   | 5,054  |  
|General and administrative      |  |                             | 2,959 |   |                            |   | 2,070  |      |  |   | 7,683  |   |  |   | 5,151  |  
|Impairment of long-lived assets |  |                             |      |   |                            |   |       |      |  |   | 243    |   |  |   |       |  
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses        |  |                             | 6,600 |   |                            |   | 6,596  |      |  |   | 18,197 |   |  |   | 17,927 |  
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Operating income                |  |                             | (924  | ) |                            |   | 1,581  |      |  |   | 438    |   |  |   | 6,821  |  
|Interest income (expense), net  |  |                             | 659   |   |                            |   | 344    |      |  |   | 1,741  |   |  |   | 861    |  
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income before income taxes      |  |                             | (265  | ) |                            |   | 1,925  |      |  |   | 2,179  |   |  |   | 7,482  |  
|Income tax expense (benefit)    |  |                             | 156   |   |                            |   | (347   | )    |  |   | 3,085  |   |  |   | (2,056 | )
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)               |  | $                           | (421  | ) |                            | $ | 2,272  |      |  | $ | (906   | ) |  | $ | 9,538  |  
|                                |  |                             |       |   |                            |   |        |      |  |   |        |   |  |   |        |  

Three Months Ended March 31, 2006 and March 31, 2005

Revenues.

Revenues were $8,801,000 for the three months ended
March 31, 2006, compared to $11,194,000 for the three months ended March 31, 2005, a decrease of $2,393,000, or 21%. Direct subscription revenues were $8,109,000, for the three months ended March 31, 2006, representing 92% of
revenues, compared to $10,643,000, for the three months ended March 31, 2005, representing 95% of revenues, a decrease of $2,534,000 or 24%. Revenues from our indirect channel partnerships were $692,000 or 8% of total revenue for the three
months ended March 31, 2006, compared to $551,000 for the comparable period at March 31, 2005, an increase of $141,000 or 26%. We continued to shift our focus to indirect channel partnerships which results in recording net revenues rather
than gross and was the primary cause of our revenue decline.

Cost of sales. Cost of sales was $3,125,000 for the three months ended March 31,
2006, compared to $3,017,000 for the three months ended March 31, 2005, an increase of $108,000, or 4%. Cost of sales declined along with revenues and number of direct customers, but was off-set by increasing expenditures for acquisition of
mobile customers. As a result of our focus change to indirect channel partnerships, direct channel billing fees decreased to $1,280,000, for the three months ended March 31, 2006, compared to $1,549,000 for the three months ended March 31,
2005, or 17%. Costs for mobile phone handsets and fulfillment related expenses are charged to cost of sales, net of customer re-imbursement for freight and handling. The rising mix of lower priced indirect customers combined with the cost of mobile
customer acquisition reduced our gross margin from 73% for the months ended March 31, 2005, to 64% for the three months ended March 31, 2006.

Sales and marketing. Sales and marketing expenses were $2,270,000, or 26% of revenues, for the three months ended March 31, 2006, compared to $2,748,000, or 25% of revenues, for the three months ended March 31, 2005, a
decrease of $478,000. Sales and marketing expenses decreased due to reduced customer acquisition spend of $1,141,000 offset by increased personnel costs of $143,000 and additional expenses related to our call center of $490,000. Previously, the call
center performed a technical support role and its expenses were allocated across all three operating expense categories. The focus of our call center has shifted from technical support to landline customer retention and the related costs are now
charged to sales and marketing.

Research and development. Research and development expenses were $1,371,000, or 16% of revenues, for the three
months ended March 31, 2006, compared to $1,778,000, or 16% of revenues, for the three months ended March 31, 2005, a decrease of $407,000, or 23%.



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The decrease in research and development expenses was due to the shift in focus and in costs of the call center to sales
and marketing which reduced research and development costs by $363,000. This decrease was partially offset by the write-off of the unamortized cost of a license totaling $102,000 as a determination was made not to pursue use of the technology.

General and administrative. General and administrative expenses were $2,959,000, or 34% of revenues for the three months ended March 31, 2006,
compared to $2,070,000, or 18% of revenues, for the three months ended March 31, 2005, an increase of $889,000, or 43%. The increase in general and administrative expenses was due to an increase in legal expenses related to litigation,
personnel or employee related costs.

Income tax provision. We recognized an income tax provision for the three months ended March 31, 2006 and
an income tax benefit for the three months ended March 31, 2005 of $156,000 and $(347,000), respectively Pursuant to FAS 109, the Company is required to evaluate the amounts of deferred tax and other related tax accounts of the balance sheet.
As part of this analysis, the Company recorded a tax provision of $156,000 in the quarter. Any changes to the tax liability account in the 4th quarter will be expensed to the tax provision in that quarter.

Net income (loss). The net loss was $(421,000) for the three months ended March 31, 2006, compared to net income of $2,272,000 for the three months ended
March 31, 2005. The shifting focus on indirect customers reduced profits by $100,000, and combined with $890,000 increasing in litigation related legal costs and $503,000 increase in tax provisions to reduce net profits by $2,693,000 or 119%
from the same period last year.

Nine months Ended March 31, 2006 and March 31, 2005

Revenues. Revenues were $28,910,000 for the nine months ended March 31, 2006, compared to $33,908,000 for the nine months ended March 31, 2005, a
decrease of $4,998,000, or 15%. We shifted our focus to indirect channel partnerships which results in recording net revenues rather than gross and lower prices overall. Direct subscription revenues were $27,010,000, for the nine months ended
March 31, 2006, representing 93% of revenues, compared to $32,590,000, for the nine months ended March 31, 2005, representing 96% of revenues, a decrease of $5,580,000 or 17%. Revenues from our indirect channel partnerships were $1,900,000
or 7% of total revenue for the nine months ended March 31, 2006, compared to $1,318,000 for the comparable period at March 31, 2005, an increase of $582,000 or 44%. Lower prices attributed to the shifting subscriber mix resulted in a
$3,600,000 decrease in revenue during the nine months ended March 31, 2006 as compared to the same period last year. In addition our average total subscriber base declined from 856,000 in the nine months ended March 31, 2005 to
approximately 763,000 in the current period, thus reducing revenues $1,400,000.

Cost of sales. Cost of sales was $10,275,000 for the nine months
ended March 31, 2006, compared to $9,160,000 for the nine months ended March 31, 2005, an increase of $1,115,000, or 12%. Cost of sales increased as mobile customer acquisition costs of $1,200,000 including the cost of mobile phones and
fulfillment expenses, are charged to cost of sales. As a result, our gross margins decreased from 73% for the nine months ended March 31, 2005 to 64% for the nine months ended March 31, 2006.

Sales and marketing. Sales and marketing expenses were $6,406,000, or 22% of revenues, for the nine months ended March 31, 2006, compared to $7,722,000, or
23% of revenues, for the nine months ended March 31, 2005, a decrease of $1,316,000. Sales and marketing expenses decreased due to reduced customer acquisition spend of $3,810,000 offset by additional expenses related to the reclassification of
costs related to our call center of $989,000, increased personnel costs of $529,000 and increased public relations costs of $95,000. Previously, the call center performed a technical support role and its expenses were allocated across all three
operating expense categories. The focus of our call center has shifted from technical support to landline customer retention and the related costs are now charged to sales and marketing.

Research and development. Research and development expenses were $3,865,000, or 13% of revenues, for the nine months ended March 31, 2006, compared to $5,054,000, or 15% of revenues, for the nine months
ended March 31, 2005, a decrease of $1,189,000, or 23%. The decrease in research and development expenses was due primarily to the shift in focus and in costs of the call center to sales and marketing which reduced research and development
costs by $724,000.

General and administrative. General and administrative expenses were $7,683,000, or 27% of revenues for the nine months ended
March 31, 2006, compared to $5,151,000, or 15% of revenues, for the nine months ended March 31, 2005, an increase of $2,532,000, or 49%. The increase in general and administrative expenses was due primarily to an increase in accounting and
legal, bad debt, insurance, investor relations, and employee-related costs. Specifically, personnel costs increased $210,000, insurance costs increased $140,000 (primarily directors & officers liability insurance), litigation related legal
costs increased $1,215,000 and bad debts expense increased $542,000 in the nine months ended March 31, 2006 as compared to the same period in 2005. The increase in bad debts expense is attributable to a higher local exchange carrier (LEC)
reject rate in the nine months ended March 31, 2006, and the increase in personnel costs is due to increased finance staff necessary to meet the needs of a public company.



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Impairment loss. In the nine months ended March 31, 2006, we determined based on an analysis of future cash
flows that our investment in and receivable from a company in which we had a minority interest was other than temporarily impaired. Accordingly, we recorded an impairment loss in the amount of $253,000 which was partially offset by a gain of $10,000
on the sale of an asset that had previously been written off.

Income tax provision. We recognized an income tax provision for the nine months ended
March 31, 2006 and an income tax benefit for the nine months ended March 31, 2005 of $3,085,000 and $(2,056,000), respectively. In prior periods we have recognized a tax provision benefit related to the reduction of the valuation allowance
associated with the deferred tax asset. During the nine months ended March 31, 2006, the Company recorded a full valuation allowance against its deferred tax asset of $5.4 million reflecting the fact that we have not determined that it is more
likely than not that we will be able to use our deferred tax assets to offset income taxes payable as we currently project six quarters of losses due to investing in the indirect channel partnership opportunity. The tax provision for the nine months
ended March 31, 2006 reflects the recording of this valuation allowance. We will continue to assess the likelihood of realization of our net deferred tax assets and will adjust the valuation balance accordingly.

Net income (loss). The net loss was $(906,000) for the nine months ended March 31, 2006, compared to net income of $9,538,000 for the nine months ended
March 31, 2005, a decrease of $10,444,000 or 109%. The decrease in net income was primarily the result of the $5,141,000 increase in our tax provision, $1,215,000 increase in legal costs from litigation, $1,200,000 increased cost of sales
related to mobile phones, shifting focus from direct to indirect subscribers reduced profits by $800,000, increased general and administrative cost of $1,520,000 related to operating as a public company, increased bad debt expenses from LEC
billings, offset by $1,080,000 of increased interest earned on cash and marketable securities.

Liquidity and Capital Resources

Cash, cash equivalents and marketable securities increased $5,478,545 over the comparable balance at June 30, 2005. This increase was caused primarily by cash from
operating activities of $5,425,000 and proceeds from exercises of options and warrants of $1,361,000 Although we are currently forecasting losses for the next six quarters of approximately $10 million in the aggregate as a result of investment in
indirect channel partnership opportunities, we expect that our cash, cash equivalents and marketable securities of $62,302,000 at March 31, 2006 will be adequate to fund our operations for at least the next twelve months. However, we will
reexamine our cash requirements periodically in light of changes in our business.

Risks Related To Our Business

Our ability to successfully generate increased revenues and profits will be dependent upon our success in entering into and managing indirect distribution
relationships.

We grew our business by directly marketing our services to consumers and small businesses through Internet advertising. We intend to
attempt to grow our business by promoting our services to users through indirect distribution arrangements in which we enter into distribution agreements with telecommunications service providers, which agree to distribute our services
to their subscribers. We do not have significant experience in developing and managing those indirect relationships. There typically is a long lead time required to conclude agreements for such arrangements, additional time is thereafter required to
implement each agreed-upon arrangement, and the actual pace of implementation is dependent upon cooperation and support from the companies with which we enter into those arrangements. In addition, even if we are able to put such indirect
distribution relationships in place, the extent to which the service providers customers subscribe for our services will be dependent in substantial part upon the pace and manner in which the service provider implements and promotes our
services, which are outside of our control. If we are unable to successfully implement those indirect distribution relationships, then we may not realize substantial growth in our subscribers for our services, we will not realize substantial growth
in revenues or profitability, and our results of operations and financial condition will be adversely affected.

We may suffer losses from operations
and reduce our accumulated cash reserves as we shift resources from our profitable direct distribution business and focus our business and investments on indirect distribution of our services.

We have elected to reduce the amount of resources that we are devoting to our legacy business in which we had marketed and distributed our services directly to users, and
instead to expand the resources that we are investing in the development and marketing of our services through indirect distribution arrangements. As a result, we expect to realize lower revenues from our legacy business. However, we do not expect
to begin generating substantial revenues from indirect distribution arrangements for at least several quarters. That delay in generating substantial revenues is attributable to a number of factors, including the time period required to



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develop indirect distribution relationships with telecommunications carriers, the time required to implement
technological changes to our services in order to make them compatible with the communications infrastructure of carriers with which we enter into indirect distribution relationships, and the time required to successfully market our services to
those carriers customers and persuade those customers to subscribe for our services. As we undergo this transition from a business based upon our traditional landline services sold directly to the consumer, to one based primarily upon the
delivery of services through indirect distribution relationships, we are likely to realize losses from operations and reduce our accumulated cash reserves.

Our ability to successfully implement indirect distribution arrangements is dependent upon our ability to integrate our technology with that of the companies that distribute our services.

In order for our indirect distribution arrangements to be successful, the companies with whom we enter into indirect distribution arrangements must be able to integrate
our services with their own service offerings. That integration process requires that our technology operate effectively with the service platforms from which those companies deliver telecommunications services to their customers and meet the
technical specifications and operating parameters imposed by companies with which we are seeking indirect distribution relationships. The integration of our services with the service platform of those other companies is a complex process that
requires not only that our respective technology platforms operate together, but also that our engineering departments work effectively together at a technical level in integrating our respective services. Those tasks require time, and we may
encounter technical difficulties that occasion delay. We also may encounter some technical difficulties that adversely affect the customers ability to fully utilize our services or even our ability to integrate our services at all. If we are
unable to overcome those challenges, then our indirect distribution strategy may be adversely affected, and we may not be able to achieve the revenue and profitability gains that we are seeking to achieve.

The use of indirect distribution arrangements may cause us to realize lower revenues and profitability than we traditionally have realized from direct
distribution of our services.

We expect that the principal growth in subscribers will come primarily from the implementation of indirect distribution
arrangements. While these arrangements typically deliver subscribers to us at a lower subscriber acquisition cost than our traditional sources of subscribers, they also tend to generate a lower average revenue per user, or ARPU, than the
traditional direct sources of subscribers. In order to achieve substantial future revenue growth from these indirect distribution arrangements, we will need to implement indirect distribution arrangements that afford us broad
exposure to significant numbers of potential subscribers, and we will need the other parties to those arrangements to cooperate with us in distributing our services to their customers. If we are unable to accomplish those objectives, then we may not
achieve future revenue growth, and our results of operations will be adversely affected.

If telecommunications customers integrate their landline and
mobile services at a rate that is slower than what we predict, then we may experience delays in realizing growth in revenues and profitability from our services.

Our services allow users to integrate their landline telephone services with their other telecommunications services (e.g. mobile). We believe that there is an opportunity for the marketing and distribution of
our services because of that integration, or convergence, of telecommunication services. We therefore have decided to devote substantial resources to indirect marketing and distribution of our services. If the pace of that convergence of
landline and other telecommunications services unfolds more slowly than we currently foresee it occurring, then the proportion of mass market consumers who are ready to subscribe for our mobile services may be much smaller than is necessary to
support substantial growth in our revenues and profitability. If the proportion of consumers who subscribe for our services is correspondingly lower, then our results of operations and financial condition will be adversely affected.

Because we are unable to predict with precision the rate at which we will acquire paying subscribers for our services through the indirect distribution relationships
that we will be emphasizing, our results of operations may be correspondingly less predictable, our stock price therefore may be more volatile, and our stockholders may suffer losses.

From our legacy business, which involved the direct marketing and distribution of our services to customers, we have assembled a substantial amount of data that allowed us to predict our subscriber counts, revenues,
and profits in that legacy business with some reliability. As our business increasingly emphasizes the delivery of our services through indirect distribution relationships, however, we will be operating without historical data that would allow us to
predict with any precision the rate at which our services will be accepted by consumers or the prices at which consumers may be willing to subscribe for those services. Consequently, we may experience significantly greater swings in our revenues and
profitability than in the past, our stock price may become increasingly volatile, and our stockholders may realize losses in the value of their shares.



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If network service providers elect to bundle services similar to ours that they obtain from other providers or to
develop such services themselves as part of their product offering, we could lose many of our paid subscribers.

The market for communications and
information services is competitive, and many service providers attempt to attract and retain subscribers by offering a variety of services. While service providers that provide Internet call waiting and call management services generally impose a
separate charge, those service providers may in the future bundle such services with their other service offerings, thereby effectively offering these services for no incremental fee. If we lose subscribers to those network service providers that
bundle services that are competitive with ours and we are unable to find replacement subscribers willing to pay for our services, our business, revenues and profitability would be adversely affected.

Increased marketing costs for Internet advertising may cause further erosion in our traditional landline business.

Our subscriber acquisition costs for our traditional land-line customers are dependent largely upon our ability to purchase multiple types of advertising at a reasonable
cost. Our advertising costs vary over time, depending upon a number of factors, some of which are beyond our control, such as seasonality, the particular mix of advertising we use and the rate at which we convert potential subscribers into paid
subscribers, and consolidation among companies that control advertising channels. We have experienced an increase in subscriber acquisition costs in the recent periods. Given our belief that our revenues from our traditional landline business will
decline over time, we have decided not to increase the amount of money that we spend on Internet advertising for our landline services. As a result, we are realizing both reduced marketing expenditures and a higher unit cost for the advertising
services that we purchase. We expect that those two factors will occasion an acceleration in the decline of our landline business over time.

We are
dependent upon billing arrangements with regional telephone companies for collecting fees from many of our landline subscribers.

We currently collect
the majority of our revenues through billing arrangements in which our subscribers regional telephone companies collect our service fees from our subscribers and forward those fees to us. We collect the remainder of our revenues through our
subscribers credit cards and checks. If the telephone companies terminated those billing arrangements, or if the cost of those arrangements increased significantly, we may be unable to continue to collect a significant portion of our revenues
in this manner, and instead would have to collect those revenues through use of subscribers credit cards, by having subscribers mail checks to us, or by other means. Because many subscribers prefer to pay for our services through their
telephone bills, any need to rely upon alternative means to collect a significant portion of our revenues may lead to a loss of a substantial portion of the subscribers who currently pay for our services as part of their monthly bill from their
telephone company, a decline in the rate at which we increase the number of our paid subscribers, or significant delinquencies in payments by our subscribers. If we are not able to successfully manage and maintain these billing relationships, our
bad debt reserves may increase and we may lose subscribers that prefer paying for our services on their local telephone bill.

If we fail to maintain
effective internal financial and managerial systems and procedures, our results of operations may be adversely affected.

As we expand our operations
and offer new services, there is a risk that our systems and procedures may not be adequate to support our operations or ensure proper identification of and proper accounting treatment for our activities. Our failure to maintain and implement such
adequate systems and procedures could adversely affect the information on which we base our decisions, thereby causing us to make inappropriate business decisions. Those incorrect decisions in turn, could adversely affect our business, financial
condition, and results of operation.

We face competition from well-capitalized hardware vendors, software vendors and service providers against whom we
may not be able to successfully compete.

Competition in the communications and information services industries is intense. We face competition for our
offerings from Internet service providers, such as AOL, landline and wireless telephone companies, such as AT&T, cable companies and other communications hardware, software and services vendors. These companies are better capitalized, have
greater name recognition and significantly larger existing subscriber bases than we do. We may also face competition in the future from communications hardware and software companies that are currently focused on other markets. If these or other
companies provide services similar to ours, we may not be able to compete effectively, which would harm our results of operations and financial condition.



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There are limited barriers to entry for other companies to provide services that compete with ours.

Telecommunications services were historically provided by companies that made substantial capital investments in their networks. The size of those investments and the
time required to deploy those networks served as significant barriers to entry into such markets. In contrast, we provide software-based enhanced services that do not require substantial capital expenditures to deploy and maintain. As a result,
other companies with strong technical staffs and knowledge of the communications and information services industries could compete with us without facing significant capital expenditures or other barriers to entry. As a result, we may face
increasing competition from companies with significantly greater resources than we have, which may force us to reduce our prices and increase our operating expenses to remain competitive. If we are not able to compete successfully with these
companies, we may lose customers or fail to grow our business as we anticipate, either of which could harm our financial condition, results of operations and prospects.

We rely upon the networks of numerous long-distance and local carriers to provide services to our subscribers. If the cost of these services were to increase, we may not be able to profitably provide our services
to our subscribers.

In providing services to our subscribers, we incur a number of underlying telecommunications costs which are beyond our control. In
order to deliver our services to our subscribers, our customers must subscribe to certain ancillary services from their telecommunications providers that re-route certain telephone calls from our subscribers telephone lines to toll-free
numbers that we have leased at our software-based switching facility, which facilitates the receipt of the call by the number that the subscribers designate. Our services rely in part upon the toll-free long-distance and local services that we
purchase from network service providers. The cost of these services, which we integrate into our service offerings, or which subscribers assume directly, is beyond our control and may increase for a number of reasons, including:



| |  |  | a general increase in wholesale long-distance rates or charges for call forwarding services;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | an election by service providers to implement a new pricing structure on the services that we currently purchase;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | an election by third-party service providers to impose charges for services which are currently toll-free; and
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | an increase in subscriber usage patterns that increases the cost of the services that we purchase
| | - |  | -------------------------------------------------------------------------------------------------

Our ability to offer services to our subscribers at competitive rates is partially dependent upon our ability to use that toll-free telephone network and our subsidiarys ability to procure telephone network
access and services on a reliable basis and at reasonable prices. If we are unable to effectively manage the cost of our underlying network services, then our pricing structure with a significant number of our subscribers would increase, which could
make it difficult to conduct business at attractive margins.

There are a limited number of long-distance and interconnection service providers that are
able to provide the services on which we rely.

We currently have contracts with four service providers for long-distance services, and our wholly-owned
subsidiary, Liberty Telecom, LLC also has interconnection agreements with other telecommunications companies, which together provide us with services that we integrate into our enhanced offerings. Each of those contracts may be terminated without
cause by the service provider upon advance written notice. The required notice period, in each instance, is less than the amount of time that we would likely need to negotiate a contract with a successor provider and modify our system to re-route
our subscribers inbound calls to that successors network. In addition, there are only a limited number of service providers with which we can contract to provide these services. As a result, if one or more of the service providers from
which we currently procure long-distance or interconnection services were to terminate our existing contractual relationships, we may not be able to locate a substitute provider on a timely basis and upon reasonable terms, if at all, in order to
avoid a disruption or loss of service to our subscribers. If we are not able to purchase access to sufficient long-distance and interconnection services at reasonable prices, we may not be able to profitably provide our services to our subscribers
and our operating results and financial condition would be harmed.

We rely upon the Internet and other networks controlled by third parties to provide
our services, and if we are not able to maintain access to these networks at reasonable rates, we may not be able to profitably provide our services.

We provide our services by integrating and enhancing underlying services on other companies networks that rely on the public switched telephone network, across the private networks constructed and owned by other companies such as
those in the cable



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industry, and across the Internet. If the owners of any one or more of those networks were either to refuse to transport
calls to our subscribers, or were to impose significantly higher charges for those calls, or if applicable regulations were to impose significantly higher charges for those calls, we would likely face increased operating costs, our profitability
could suffer and our business could be harmed.

We are dependent upon the availability of reasonably priced call-forwarding services to provide our
services to the majority of our subscribers in a cost-effective manner.

Customers who subscribe to certain of our services typically subscribe to
call-forwarding services from their local telephone service provider. Generally, these call-forwarding services are available to our subscribers at a reasonable price. If the service providers do not provide these services at a reasonable price, the
overall price of obtaining our services may exceed the amount that our current and potential subscribers are willing to pay. If the prices for these services increase, a significant number of our subscribers may terminate their subscriptions for our
services.

Because the secondary facility for our subsidiarys existing telephone switching equipment is not yet fully operational, a catastrophic
event at Liberty Telecoms primary facility would cause the disruption of our services to subscribers.

Our enhanced services currently depend on
telecommunications services from our subsidiary, Liberty Telecom, which are provided using a single call-switching facility in Reno, Nevada. A catastrophic event, such as an earthquake or a fire, that destroys part or all of the facility would
disrupt our business and prevent us from providing services to our subscribers for an extended period of time. While Liberty Telecom is nearing completion of our secondary call-switching facility and we already are using this facility to provide
some data and voice services to our subscribers, the second facility may not be fully operational on a timely basis, or at all. Because our subscribers expect our services to match the high reliability that characterizes services in the
communications and information services industries generally, any failure in our ability to service our subscribers could cause us to lose significant numbers of subscribers, and make it more difficult to obtain new paid subscribers.

A system failure or a breach of our network security could delay or interrupt service to our subscribers or lead to a misappropriation of our confidential
information.

Our operations are dependent upon our ability to protect our computer network from interruption, unauthorized entry, computer viruses and
other similar events. In the past, we experienced one outage of our entire system which occurred following the failure of redundant components and lasted approximately two hours. From time to time, we have also experienced limited system
interruptions. While these interruptions did not significantly harm our business, our existing and planned precautions may not be adequate to prevent a significant interruption in the operation of our network in the future. Despite the
implementation of security measures, our infrastructure also may be vulnerable to computer viruses, hackers or similar disruptive problems caused by our subscribers, employees or other Internet users who attempt to invade public and private data
networks. A system failure or a breach of our security measures may lead to a disruption in service, or the misappropriation of confidential information, which may result in significant liability to us and also may deter current and potential
subscribers from using our services. Any system failure or security breach that causes interruptions or data loss in our operations or in the computer systems of our subscribers could cause us to lose paid subscribers and harm our business,
prospects, financial condition and results of operations.

If we do not successfully anticipate the service demands of our subscribers, we may be unable
to successfully attract and retain subscribers.

We must accurately forecast the features and functionality required by our current and potential
subscribers. In addition, we must design and implement service enhancements that meet subscriber requirements in a timely and efficient manner. We may not successfully determine subscriber requirements and, therefore, may not be able to satisfy
subscriber demands. Furthermore, as our current subscribers needs change, we may not be able to identify, design and implement in a timely and efficient manner services incorporating the type and level of features desired by our subscribers.
If we fail to accurately determine or effectively market subscriber feature requirements or service enhancements, we may lose current subscribers or fail to attract new subscribers, and may be unable to grow our revenues.

Other persons may assert claims that our business operations or technology infringe or misappropriate their intellectual property rights, which could increase our
costs of operation and distract management and could result in expensive settlement costs.

Other companies or individuals, including our competitors,
may claim that we infringe or misappropriate their intellectual property rights. From time to time, third parties have contacted us, asserting that we may infringe their intellectual property rights. For



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example, in December 2003 and April 2004, a major communications infrastructure company delivered to one of our
distributors two letters, in which we were not named, offering to negotiate with our distributor a nonexclusive license to certain patents that the infrastructure company believed to be relevant to our service and implying that our service may
infringe those patents. As part of this process, we have received a legal opinion from our intellectual property counsel that our services do not infringe the patents of this infrastructure company, although there is no assurance that a court would
agree with that opinion.

We received a letter from America Online, Inc., or AOL, in September 2004 in which AOL offered to discuss with us a license to
U.S. Patent No. 5,809,128, Method and apparatus permitting notification and control of blocked incoming calls over a data network, or the `128 patent, and implying that our services may infringe the `128 patent. In 2000 and 2001, we
had periodically discussed a license for the `128 patent with Infointeractive Services, the company that owned the `128 patent and was subsequently acquired by AOL. We have received an opinion of counsel that our operations did not and do not
infringe the `128 patent, although we can offer no assurance that a court would agree with that opinion. AOL has substantial resources, and may elect to assert a claim that our operations infringe the `128 patent. If such a claim is asserted and we
are unable to resolve the matter by agreement, then we would likely incur substantial attorneys fees to defend against any such claim. The outcome of any such claim is uncertain, and an adverse judgment would likely have a material adverse
impact upon our business and results of operations.

On August 24, 2004, j2 Global Communications, Inc., or j2, filed a complaint against the Company
in the United States District Court for the Central District of California alleging that the Companys operations infringe U. S. Patent No. 6,350,066, or the `066 patent. j2s complaint seeks unspecified damages and permanent
injunctive relief, among other relief. On September 14, 2004, the Company filed its response to the complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On December 30, 2004, j2 filed
a first amended complaint, alleging that in addition to infringing the 066 patent, the Company infringes U.S. Patent Nos. 6,564,321, or the `321 patent, and 6,208,638, or the `638 patent. On January 31, 2005, the Company filed its
response to the first amended complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On April 21, 2005, j2 filed a second amended complaint, alleging that the Company infringes the claims of U.S.
Patent No. 6,857,074, or the `074 patent. On May 10, 2005, the Company filed its response to the second amended complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On December 15,
2005, a Markman hearing was held in the case. Before any order issued from that hearing, however, on January 11, 2006, the Court stayed the action pending reexamination of some of the patents in the United States Patent and Trademark Office, or
USTPO. It is unclear what the duration of that stay will be. The Companys intellectual property counsel has provided to the Company opinions that the Company does not infringe the claims of the asserted patents. By reason of those opinions,
the Company does not believe that it infringes the claims of those patents. However, if the USPTO affirms the validity of the patents and trial resumes, then the Companys efforts to defend against j2s assertions will be expensive and
time-consuming.

The Company in October 2004 received a letter from counsel to Web Telephony, LLC, or Web Telephony, implying that our operations infringe
certain claims in U.S. Patent No. 6,445,694, Internet Controlled Telephone System, or the `694 patent, and U.S. Patent No. 6,785,266, Internet Controlled Telephone System, or the `266 patent. On January 19,
2005, the Company filed in the United States District Court for the Central District of California an action for declaratory relief, in which the Company sought to have the court declare that the Company does not infringe the `694 patent or the `266
patent. Web Telephony subsequently counterclaimed, alleging infringement of the `694 and `266 patents. Effective March 28, 2006, the Company and Web Telephony executed a definitive settlement agreement under which the parties waived all claims
against each other with respect to the 694 and the 266 patents, and Web Telephony granted to the Company a worldwide, fully paid-up, nonexclusive license entitling the Company to practice the claims of the 694 and the 266
patents. The parties, by stipulation, subsequently dismissed the litigation.

On July 1, 2005, Catch Curve, Inc., or Catch Curve, filed a complaint
against the Company in the United States District Court for the Central District of California, alleging that the Companys operations infringe U.S. Patents No. 6,785,021, or the `021 Patent, U.S. Patent No. 6,643,034, or the `034
Patent, U.S. Patent No. 5,291,302, or the `302 Patent, and U.S. Patent No. 4,994,926, or the `926 Patent. The Company thereafter filed its answer, denying the allegations and asserting certain counterclaims and affirmative defenses. Catch
Curve thereafter filed its answer to those counterclaims, denying the Companys allegations. A trial date of October 2, 2007, has been set in this case. The Company has received from intellectual property counsel opinions that the
Companys present operations do not infringe the claims of the `021 patent, the `034 patent, the `302 patent, or the `926 patent. By reason thereof, we presently do not believe it is probable that we will suffer, by reason of such litigation, a
material loss. However, it is premature to reach any definitive conclusions in that regard.

A determination that we have infringed the intellectual
property rights of a third party, including in any of the above-referenced matters, could expose us to substantial damages, restrict our operations or require us to procure costly licenses to the intellectual property that is the subject of the
infringement claims. Such a license may not be available to us on acceptable terms or at all. Any effort to defend ourselves from assertions of infringement or misappropriation of a third partys intellectual property rights, whether or not we
are successful, would be expensive and time-consuming and would divert management resources. Any adverse determination that we have infringed the intellectual property rights of a third party, or the costs we incur to defend ourselves against such
claims, whether or not we are successful, would have a material adverse impact on our business and results of operations.



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Our customers or other companies with whom we have a commercial relationship could also become the target of litigation
relating to the patent and other intellectual property rights of others. This could trigger support and indemnification obligations, which could result in substantial expenses, including the payment by us of costs and damages relating to patent
infringement. In addition to the time and expense required for us to meet our support and indemnification obligations, any such litigation could hurt our relations with our customers and other companies. Thus, the sale of our services could
decrease. Claims for indemnification may be made by third parties with whom we do business and such claims may harm our business, prospects, financial condition and results of operations.

We may not be able to protect and enforce our intellectual property rights, which could impair our ability to compete and reduce the value of our services.

We rely primarily upon a combination of trademark, trade secret, copyright and patent law protections, and contractual restrictions to protect our
proprietary technology. Those measures may not provide meaningful protection. For example, any rights granted under any of our existing or future patents may not provide meaningful protection or any commercial advantage to us. Such patents could be
challenged or circumvented by our competitors or declared invalid or unenforceable in judicial or administrative proceedings. The failure of any patents to adequately protect our technology would make it easier for our competitors to offer similar
services. With respect to our proprietary rights, it may be possible for third parties to copy or otherwise obtain and use our proprietary technology or marks without authorization or to develop similar technology independently. Monitoring
unauthorized use of our proprietary technology or marks is difficult and costly. We may not be able to detect unauthorized use of, or to take appropriate steps to enforce, our intellectual property rights, particularly in foreign countries where the
laws may not protect our proprietary rights as fully as in the United States. If we commence an action to terminate a third partys authorized use of our intellectual property rights, we may face challenges to the validity and enforceability of
our proprietary rights and may not prevail in any litigation regarding those rights. Any efforts to enforce or determine the scope of our intellectual property rights, whether initiated by us or a third party, would be expensive and time-consuming,
would divert management resources and could adversely affect our business, whether or not such litigation results in a determination favorable to us.

If we are unable to obtain additional telephone numbers, we may not be able to grow our subscriber base.

Our future success will depend in
part upon our ability to procure sufficient quantities of telephone numbers in area codes where our subscribers are located at costs we can afford. The ability of telecommunications carriers to provide us with telephone numbers to be used in
conjunction with our services depends on applicable regulations, the practices of telecommunications carriers that provide telephone numbers, and the level of demand for new telephone numbers. In addition, the Federal Communications Commission, or
FCC, has regulations concerning numbering resource utilization. If Liberty Telecom does not sufficiently utilize the numbers assigned to it, it may have to relinquish control of those unused numbers. Furthermore, the FCC and state public utility
commissions periodically review numbering utilization, and may in the future propose additional changes to regulations governing number assignment and availability. Failure to have access to telephone numbers in a timely and cost-effective manner,
or the loss of use of numbers we have accessed or may access, could prevent us from entering some markets or slow our growth in the markets in which we currently sell our services.

Our Enhanced Services Platform is a complex hardware and software system that could fail and cause service interruptions to our subscribers.

Our hardware and software systems are complex and are critical to our business. If our systems fail, our subscribers might experience reduced levels of service or service interruptions. Software-based services, such
as ours, may contain undetected errors or failures when introduced or when new versions are released. Errors may be found in our software before or after commercial release, and, as a result, we may experience development delays or a disruption of
our services. Failures in our system or interruptions to our service could cause us to lose paid subscribers and harm our business, prospects, financial condition and results of operations.

If we are unable to maintain access to national IP-protocol based networks, then our business and results of operations may be adversely affected.

Historically, to obtain our services, our subscribers had their calls routed on long-distance circuits through the public switched telephone network to our software
switching facilities in Nevada. That structure requires that we often pay for long-distance telephone service. We expect to increasingly rely upon the public Internet or third-party managed Internet protocol networks, which would not change how we
provision services to our subscribers, but would allow us to reduce our cost of sales by using more of the less expensive Internet and local telephone network minutes and fewer of the more expensive long-distance telephone network minutes.



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We recently entered into a contract with a provider of these Internet and managed Internet protocol network services,
which is a privately managed Internet where access is controlled to ensure quality of service. If we are unable to establish and effectively manage such relationships on a cost-effective basis, or if the costs associated with Internet and local
telephone network minutes increase, then our ability to manage our costs may be adversely affected and our results of operations may suffer.

Our
success depends in large part upon our retention of our executive officers and our ability to hire and retain additional key personnel.

Our future
performance depends in large part upon the continued services of our executive officers and other key technical, operations and management personnel. Our future success also depends on our continuing ability to attract and retain highly qualified
technical, operations and managerial personnel. Competition for such personnel is intense, and we may not be able to retain our key employees or attract or retain other highly qualified technical, operations and management personnel in the future.
The loss of the services of one or more of our executive officers or other key employees or our inability to attract and retain additional qualified personnel could harm our business and prospects.

We may acquire other businesses or license technologies, and if we do, they could prove difficult to integrate, disrupt our business, dilute stockholder value and
adversely affect our operating results.

Our business strategy in the future may include the acquisition of other businesses or licensing of
technologies. We may not be able to identify, negotiate, integrate or finance any such future acquisition or license successfully. We have not acquired any companies to date and have no arrangements or agreements with respect to any potential
acquisition and, therefore, have no experience with integrating other business operations or technologies with ours. If we engage in any such strategic transaction, then we may encounter unforeseen operating challenges and expenses that may require
a significant amount of management time that otherwise would be devoted to running our operations. If we undertake acquisitions or other strategic transactions, then we may issue shares of stock that dilute the interests of existing stockholders;
and we may incur debt, assume contingent liabilities, or create additional expenses related to amortizing intangible assets, any one or more of which may harm our business and results of operations.

Risks Related To Our Industry

We may not be able to respond to
the rapid technological change of the communications and information services industries and, as a result, our business may be adversely affected.

The
communications and information services industries are undergoing rapid and significant technological change. We cannot predict the effect of technological changes on our business. We expect that new services and technologies will emerge in the
markets in which we compete. Those new services and technologies may be superior to the services and technologies that we provide or those new services may render our services and technologies obsolete. In addition, those services and technologies
may not be compatible with ours. If we are not able to effectively respond to technological changes, the services we provide may no longer be attractive to our current and potential subscribers and our business, prospects, financial condition and
results of operations may be harmed.

We may be required to incur significant costs to modify our systems in order to meet the requirements of the
Communications Assistance to Law Enforcement Act.

The Communications Assistance to Law Enforcement Act, or CALEA, requires telecommunications carriers
to have the capability to perform wiretaps and to record other call identifying information. There is substantial uncertainty within the industry as to how to implement these requirements with respect to packet-switched networks, such as that
operated by Liberty Telecom. As Liberty Telecom expands its service offerings, further modifications to its local switching equipment may be necessary to comply with applicable laws and regulations. On March 12, 2004, the FCC issued a public
notice seeking public comment with respect to a Petition for Rulemaking (Docket RM-10865) filed by the Department of Justice, Federal Bureau of Investigation and U.S. Drug Enforcement Agency, seeking to resolve various outstanding issues associated
with the implementation of CALEA. In response to the issues raised by the Department of Justice, the Federal Bureau of Investigation, and other law enforcement agencies, the FCC, on August 12, 2004, issued a Notice of Proposed Rulemaking and
Declaratory Ruling addressing various outstanding issues associated with the implementation of CALEA. That proceeding could result in additional regulatory burdens for us and for Liberty Telecom. Complying with CALEA and rules implementing CALEA may
require us to incur substantial costs, which could negatively impact our results of operations.



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Our services may become subject to burdensome regulations that could increase our costs or restrict our service
offerings.

We provide our services through data transmissions over public telephone lines and other facilities provided by telecommunications
companies. The underlying transmissions are typically subject to regulation by the FCC, state public utility commissions and, in the future, could become subject to regulation by foreign governmental authorities. These regulations affect the prices
that we pay for transmission services, the competition we face from communications service providers that may choose to offer enhanced services similar to ours and other aspects of our market. As a software-based provider of enhanced services, we
believe we are not currently subject to direct regulation by the FCC or generally by state public utility commissions, although our wholly-owned subsidiary, Liberty Telecom, is a telecommunications carrier subject to state and federal regulation as
a Competitive Local Exchange Carrier. As communications services increasingly are delivered over the Internet and as we expand the services that we offer, our business may become increasingly regulated. Liberty Telecom is required to have a
certificate of public convenience and necessity in order to operate in the state of Nevada as a Competitive Local Exchange Carrier. If Liberty Telecom were to lose its certificate, we may not be able to obtain access to telecommunications services
at rates or on other terms and conditions that are as favorable as those that we currently have.

As we introduce new offerings, it is possible that some
of them may fall within existing telecommunications regulations, increasing our costs. Changes in the federal and state regulatory rules, or developments in the interpretation of existing regulations, could decrease our revenue, increase our costs
or restrict our service offerings.

Future legislation, regulation, or legal decisions affecting the Internet, Internet telephony or IP-enabled services
could restrict our business, prevent us from offering our services or increase our cost of doing business.

At present there are few laws, regulations
or rulings that specifically address access to or commerce on the Internet, including the provision of Internet protocol-based telephony and other IP-enabled services. We are unable to predict the impact, if any, that future legislation, regulations
or legal decisions may have on our business. However, the growth in the market for IP-based telephony and other IP-enabled communications, and the popularity of these services, create the risk that governments and agencies increasingly will seek to
regulate services such as our current offerings. Many legislative and regulatory actions are underway or are being contemplated by federal and state authorities, including the FCC and various state regulatory agencies. For example:



| |  |  | On March 10, 2004, the FCC released a notice of proposed rulemaking (Docket 04-36) and sought public comment regarding the regulatory classification, rights and obligations of
services supported by IP technologies.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On April 21, 2004, the FCC released a narrow declaratory ruling finding that certain Internet protocol telephony services are telecommunications services upon which interstate
access charges may be assessed. Prior to this decision, the FCC had never ruled that a service relying on Internet-protocol technology was a telecommunications service. The ruling illustrates that certain Internet-protocol based services may become
subject to costs and regulations that, previously, were not thought to be applicable. This ruling, however, is not likely to have any direct effect on us in the near future.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | At an open meeting on August 5, 2005, the FCC unanimously adopted an order reclassifying wireline broadband Internet access services as information services, thereby placing
wireline broadband Internet access services within the same general regulatory framework as cable modem services. As an information service, wireline broadband Internet access, like cable modem service, no longer is subject to regulation under Title
II of the Communications Act of 1934, as amended, or the FCCs Computer Inquiry rules, but is subject to specific obligations imposed under Title I of the Act. Until the Commission releases the text of the decision, many important details
regarding the decision will remain unclear. However, the decision could potentially could enable ILECs to (1) refuse to permit subscribers to their broadband transmission services to use our enhanced services, (2) charge higher rates for
underlying broadband transmission service to subscribers to our enhanced services, or (3) bundle enhanced services that are similar to our enhanced services with their broadband transmission services at such a rate that it becomes economically
unfeasible for us to compete with the ILEC. If one or more ILECs take any of those actions with explicit or tacit permission from the FCC, then it could have a material adverse impact upon our profitability and the results of our operations.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





| |  |  | November 12, 2004, the FCC released an order preempting the September 11, 2003 order of the Minnesota Public Utilities Commission. In the preempted Minnesota Order, the
Minnesota Commission had asserted regulatory jurisdiction over Vonages DigitalVoice service and ordered Vonage to comply with all state statues and regulations relating to the offering of telephone service in Minnesota, which could have
required Vonage, among other things, to obtain operating authority, file tariffs, and provide and fund 911 emergency services. In addition to preempting the Minnesota Order, the FCC concluded that comparable regulations of other states must
likewise yield to important federal objectives, although the agency did not identify, or preempt, any specific state regulations or orders apart from the Minnesota Order. Specifically, the FCC explained that, to the extent that other
VoIP services are not the same as Vonages but share similar basic characteristics, we believe it highly unlikely that the Commission would fail to preempt state regulation of those services to the same extent. The FCC, however, did not
determine whether DigitalVoice or any other IP-enabled service is an information or telecommunications service, and thus the regulatory classification of these services under the Act remains an open issue. An appeal of the FCCs preemption
order is currently pending.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The specific services at issue in the FCCs preemption order referenced above were offered to the public as
substitutes for, or as substantially equivalent to, existing telecommunications services. In contrast, the services that we currently offer are not offered to the public as substitutes for, or as substantially equivalent to, existing
telecommunications services. Our IP-enabled services allow our customers to manage calls which are initiated by third parties to our customers and completed over the local service facilities of our customers existing telecommunications service
providers. As such, our customers could not use our service unless they are also separately receiving telecommunications services from their own service provider. Certain decisions adopted by state commissions before the FCC issued its preemption
order suggested an increased interest by some state commissions in regulating services that may



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be perceived as the functional equivalent of local phone service. If state regulators attempt to regulate the enhanced
services that we provide or determine that the enhanced services that we provide are currently subject to their regulatory provisions, then we may be faced with substantially increased regulatory burdens and costs.

Regulatory proceedings, legislative efforts and adjudications, including but not limited to some of those described above, may lead to the imposition of additional
regulatory obligations and requirements on us in the provision of our services, including but not limited to certification requirements, interstate or intrastate access charges, regulatory fees, payments to universal service support funds, taxes
related to Internet or IP-enabled communications, requirements to provide free access to certain users, regulations based on encryption concerns, consumer protection requirements and certain minimum service levels. We could conceivably become
subject to requirements and obligations not only at the federal level, but also in any of the states in which we have customers or from which third persons initiate communications to call our customers, as well as in any of those jurisdictions in
which facilities exist or activities occur which support our offerings. Further, if we expand into additional lines of business or make new service offerings, we could become subject to existing or future regulation or other legal requirements,
including but not limited to those which apply to telecommunications services and the providers of such services. The impact of federal or state legislative, regulatory, or adjudicatory actions or requirements may include an increase in our costs,
adversely affect how we conduct our business, and adversely affect our financial condition and results of operations.

Risks Related To Our Common Stock

Our executive officers, directors and 5% stockholders own a significant percentage of our stock and will be able to exercise significant influence
over stockholder votes.

Our executive officers, directors and 5% stockholders together beneficially own approximately 63.6% of our common stock,
including shares subject to options and warrants that confer beneficial ownership of the underlying shares. Accordingly, these stockholders, for the foreseeable future will continue to have significant influence over our affairs including the
election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets. This concentrated control will limit the ability of shareholders to influence corporate matters and, as a result, we may take
actions that our stockholders do not view as beneficial. For example, this concentration of ownership could have the effect of delaying or preventing a change in control or otherwise discouraging a potential acquirer from attempting to obtain
control of us, which in turn could cause the market price of our common stock to decline or prevent our stockholders from realizing a premium over the market price for their shares of our common stock.

Provisions in Delaware law and our charter documents may make it difficult for a third party to acquire us and could depress the price of our common stock.

Provisions of Delaware law, our certificate of incorporation and our bylaws could make it more difficult for a third party to acquire control of us.
For example:



| |  |  | we are subject to Section 203 of the Delaware General Corporation Law, which would make it difficult for another party to acquire us without the approval of our board of
directors;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our certificate of incorporation authorizes our board of directors to issue preferred stock without requiring stockholder approval, and preferred stock could be issued as a
defensive measure in response to a takeover proposal; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our certificate of incorporation or bylaws:
| | - |  | -------------------------------------------



| |  |  | creates a classified board of directors;
| | - |  | ----------------------------------------



| |  |  | prohibits cumulative voting in the election of directors
| | - |  | --------------------------------------------------------



| |  |  | limits the persons who may call special meetings of our stockholders; and
| | - |  | -------------------------------------------------------------------------



| |  |  | imposes advance notice requirements for nominations for election to our board of directors and for proposing matters to be acted upon by our stockholders.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

These and other provisions of Delaware law, our certificate of incorporation and our bylaws may make it more difficult for a third party to acquire us even if an
acquisition might be in the best interests of our stockholders, and the price at which shares of our common stock are purchased and sold therefore may be depressed.



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We are incurring increased costs as a result of being a public company.

As a public company, we are incurring significant additional legal, accounting and other expenses. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently
implemented by the Securities and Exchange Commission and the Nasdaq National Market, require changes in corporate governance practices of public companies. These new rules and regulations have resulted in increased legal and financial compliance
costs and management efforts and we expect those costs and efforts to continue to increase. It has become more expensive for us to obtain director and officer liability insurance, and it may become more difficult to obtain such insurance in the
future, which may cause us to accept reduced policy limits and reduced coverage or to incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified persons to
serve on our board of directors or as executive officers. We cannot predict or estimate the amount of additional costs we may incur, but these additional costs and demands on management time and attention may harm our business and results of
operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign currency exchange risk. We do not
currently do any business denominated in foreign currencies and, therefore, are not subject to any significant foreign currency exchange risk.

Interest
rate sensitivity. We had cash and cash equivalents totaling $20.6 million and marketable securities totaling $41.7 million at March 31, 2006, and cash and cash equivalents totaling $35.3 million and marketable securities totaling $26.6
million at December 31, 2005. Cash and cash equivalents are held for working capital purposes in depository accounts at FDIC-regulated banking institutions. Marketable securities consist of investment grade securities, corporate bonds, and
government and agency securities. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our cash
and cash equivalents or marketable securities as a result of changes in interest rates. Declines in interest rates, however, will reduce our future interest income.

ITEM 4. CONTROLS AND PROCEDURES

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure

None.

Item 9A. Controls and
Procedures

(a)Evaluation of disclosure controls and procedures.

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities
Exchange Act of 1934 as of the end of the period covered by this report. The evaluation included certain internal control areas in which we have made and are continuing to make changes to improve and enhance controls. In designing and evaluating the
disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to
apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

During the quarter ended March 31, 2006 we
identified a significant deficiency in our system of internal controls and operations. The term significant deficiency, as defined under standards established by the Public Company Accounting Oversight Board, refers to a
control deficiency, or combination of control deficiencies, that adversely affect a companys ability to initiate, authorize, record, process or report external financial data reliably in accordance with generally acceptable accounting
principles such that there is more than a remote likelihood that a misstatement of the companys annual or interim financial statements that is more than inconsequential will not be prevented or detected.

During the quarter ended March 31, 2006 we entered into certain transactions with third parties, but the documentation and other evidence related to certain
elements of those transactions were not disclosed to our finance department in a timely manner. All senior executives and members of the business development department have individually certified that all transactions were disclosed to finance
department. We intend to revise and enhance our approval matrix and related procedural controls.

Subject to the matters described above, our chief
executive officer and chief financial officer concluded that our disclosure controls and procedures are effective, in all material respects, to ensure that information we are required to disclose in reports that we file or submit under the Exchange
Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive
officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.



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(b) Changes in internal controls over financial reporting.

There were no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information

None.

PART IIOTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On July 1, 2005, Catch Curve, Inc., or Catch Curve, filed a complaint against the Company
in the United States District Court for the Central District of California, alleging that the Companys operations infringe U.S. Patents No. 6,785,021, or the `021 Patent, U.S. Patent No. 6,643,034, or the `034 Patent, U.S. Patent
No. 5,291,302, or the `302 Patent, and U.S. Patent No. 4,994,926, or the `926 Patent. The Company thereafter filed its answer, denying the allegations and asserting certain counterclaims and affirmative defenses. Catch Curve thereafter
filed its answer to those counterclaims, denying the Companys allegations. A trial date of October 2, 2007, has been set in this case. The Company has received from intellectual property counsel opinions that the Companys present
operations do not infringe the claims of the `021 patent, the `034 patent, the `302 patent, or the `926 patent. By reason thereof, we presently do not believe it is probable that we will suffer, by reason of such litigation, a material loss.
However, it is premature to reach any definitive conclusions in that regard.

On August 24, 2004, j2 Global Communications, Inc., or j2, filed a
complaint against the Company in the United States District Court for the Central District of California alleging that the Companys operations infringe U. S. Patent No. 6,350,066, or the `066 patent. j2s complaint seeks unspecified
damages and permanent injunctive relief, among other relief. On September 14, 2004, the Company filed its response to the complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On
December 30, 2004, j2 filed a first amended complaint, alleging that in addition to infringing the 066 patent, the Company infringes U.S. Patent Nos. 6,564,321, or the `321 patent, and 6,208,638, or the `638 patent. On January 31,
2005, the Company filed its response to the first amended complaint, denying the allegations of the complaint and alleging affirmative defenses to the complaint. On April 21, 2005, j2 filed a second amended complaint, alleging that the Company
infringes the claims of U.S. Patent No. 6,857,074, or the `074 patent. On May 10, 2005, the Company filed its response to the second amended complaint, denying the allegations of the complaint and alleging affirmative defenses to the
complaint. On December 15, 2005, a Markman hearing was held in the case. Before any order issued from that hearing, however, on January 11, 2006, the Court stayed the action pending reexamination of some of the patents in the United States
Patent and Trademark Office, or USTPO. We have received from intellectual property counsel opinions that our present operations do not infringe the claims of the `066 patent, the `638 patent, the `321 patent, or the `074 patent. By reason thereof,
we presently do not believe it is probable that we will suffer, by reason of such litigation, a material loss. However, it is premature to reach any definitive conclusions in that regard.

The Company in October 2004 received a letter from counsel to Web Telephony, LLC, or Web Telephony, implying that our operations infringe certain claims in U.S. Patent
No. 6,445,694, Internet Controlled Telephone System, or the `694 patent, and U.S. Patent No. 6,785,266, Internet Controlled Telephone System, or the `266 patent. On January 19, 2005, the Company filed in the
United States District Court for the Central District of California an action for declaratory relief, in which the Company sought to have the court declare that the Company does not infringe the `694 patent or the `266 patent. Web Telephony
subsequently counterclaimed, alleging infringement of the `694 and `266 patents. Effective March 28, 2006, the Company and Web Telephony executed a definitive settlement agreement under which the parties waived all claims against each other
with respect to the 694 and the 266 patents, and Web Telephony granted to the Company a worldwide, fully paid-up, nonexclusive license entitling the Company to practice the claims of the 694 and the 266 patents. The parties,
by stipulation, subsequently dismissed the litigation.

In September 2004, we received a letter from America Online, Inc., in which AOL offered to grant to
us a license to U.S. Patent No. 5,809,128, or the `128 patent. We and AOL are engaged in business discussions at the present time, and it is unclear how those negotiations will be concluded. We have received from intellectual property counsel
an opinion that our operations do not infringe the claims of the `128 patent. By reason thereof, we presently do not believe it is probable that we will suffer a material loss by reason of this matter, although it is premature to reach a definitive
conclusion in that regard.



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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Sales of Unregistered Securities

None.

Use of
Proceeds

On October 5, 2004, we closed the sale of 4,000,000 shares of our common stock in our initial public offering. The registration
statement on Form S-1 (Reg. No. 333-115438) we filed to register our common stock in the offering was declared effective by the SEC on September 29, 2004. After deducting expenses of the offering, we received net offering proceeds of
approximately $35.2 million. From the time of receipt, October 5, 2004, through December 31, 2005, we have not used the proceeds of this offering but have invested them into investment grade government agency and corporate debt securities.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS



|              |  |                                                                                                                                                                                  
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                      
|3.1           |  | Certificate of Amendment to Amended and Restated Certificate of Incorporation.1                                                                                                  
|              | 
|10.1          |  | Amended and Restated Employment Agreement by and between David F. Hofstatter and the Registrant dated April 7, 2006.2                                                            
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                               
|              | 
|32.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                               

---

|1 | Incorporated by reference as Exhibit 3.1 to Registrants Quarterly Report on Form 10-Q, as filed with the Commission on February 14, 2006.
|- | ------------------------------------------------------------------------------------------------------------------------------------------

|2 | Incorporated by reference as Exhibit 10.1 on Registrants Current Report on Form 8-K, as filed with the Commission on April 10, 2006.
|- | -------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                   |  |                 |  |                                             
|------------------ |  | --------------- |  | --------------------------------------------
|                   |  | CALLWAVE, INC.,
|                   |  |                
|Date: May 12, 2006 |  | By:             |  | /s/ David F. Hofstatter                     
|                   |  |                 |  | David F. Hofstatter,                        
|                   |  |                 |  | President and Chief Executive Officer       
|                   |  |                
|Date: May 12, 2006 |  | By:             |  | /s/ C. Stephen Cordial                      
|                   |  |                 |  | C. Stephen Cordial                          
|                   |  |                 |  | Chief Financial Officer                     
|                   |  |                 |  | (principal financial and accounting officer)



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EXHIBIT INDEX



|              |  |                                                                                                                                                                                  
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                      
|3.1           |  | Certificate of Amendment to Amended and Restated Certificate of Incorporation.1                                                                                                  
|              | 
|10.1          |  | Amended and Restated Employment Agreement by and between David F. Hofstatter and the Registrant dated April 7, 2006.2                                                            
|              | 
|31.1          |  | Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|              | 
|32.1          |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                               
|              | 
|32.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                               

---

|1 | Incorporated by reference at Exhibit 3.1 to Registrants Quarterly Report on Form 10-Q, as filed with the Commission on February 14, 2006.
|- | ------------------------------------------------------------------------------------------------------------------------------------------

|2 | Incorporated by reference as Exhibit 10.1 on Registrants Current Report on Form 8-K, as filed with the Commission on April 10, 2006.
|- | -------------------------------------------------------------------------------------------------------------------------------------



32